By John Spear, CFA
USAA Mutual Funds Chief Investment Officer
If there had been any remaining doubts that monetary policy and the U.S.- China trade dispute are the most potent issues facing asset markets as we head into 2019, the past few weeks of ups and downs should put those doubts to rest.
Stocks jumped in late November after Federal Reserve chair Jerome Powell indicated in late November that rates are now near neutral — neither helping nor hindering the economy — and that the central bank may slow its pace on rate hikes in 2019.
Those gains were erased within a few days when a top Chinese tech executive was arrested on a U.S. warrant. But then another big upswing when Beijing offered to buy more U.S. farm products and slash tariffs on American cars, and another drop on weak GDP data from China and the European Central Bank’s decision to tighten its money supply.
Underlying the market swings are worries about a softening global economy that could get even softer if interest rates rise too high or there’s too much more disruption to trade relationships.
And underlying the worries about global growth is the biggest worry of all — that a recession may be lurking around the corner.
Adding to the recession fears is the Treasury yield curve — as of mid- December, the yield on a 2-year government bond was only slightly lower than the yield on a 10-year bond, the result of nervous investors seeking safety from riskier assets. This type of flattening has often been a precursor to a yield-curve inversion (2-year yield above the 10-year yield). Each of the U.S. recessions since the mid-1950s has been preceded by an inverted yield curve.
Will there be a 2019 recession that ends one of the longest periods of economic expansion in U.S. history? We don’t see it happening for a couple of key reasons.
First, though there are signs that the trade standoff with China is starting to hurt some industries, the U.S. economy has been holding up well at 3+% real growth. U.S. GDP momentum is expected to lose some steam in 2019 as the stimulative effects of tax reform, regulatory easing and higher government spending continue to fade, but slower growth is a far cry from economic contraction.
And second, while an inverted yield curve has been a reliable indicator of a coming recession, the lag between the two events has been far less consistent. Over the past six decades, the time between inversion and recession has ranged between six months and two years. This brings us back to the first point — aside from the yield curve, recession indicators are scarce.
Of course, if the Fed leans unexpectedly hard into rate hikes or if the global trade regime completely unravels, we would have to revisit our position. In any event, given how much markets hate uncertainty, there is one thing we should expect in 2019 — more of the same volatility that has defined the late months of 2018.
ASSET CLASS OUTLOOK
How tough has 2018 been for investors? At this time last year, every key asset class was positive and each was doing better than this year’s best performer — U.S. large caps, which in mid-December were barely in the black on a total return basis.
Since early fall, uncertainties about interest rates and the global trade regime had been amplifying investor worries about slower economic growth. Markets appear to have moved from deep pessimism to skeptical but open to persuasion as bits of good news trickle into the markets — a welcome shift along the confidence continuum, however modest it may be.
Some high-level thoughts about 2019 for key asset classes:
The sharp volatility spikes in U.S. stocks in recent months have brought out the doomsayers, but absent a catastrophic turn in the U.S.-China trade dispute or a Fed-forced upward march in interest rates, we have a hard time joining their bleak outlook for 2019.
But at the same time, we cannot at this point get behind the bold bulls who expect the S&P 500 to be 15%-20% higher by this time next year.
Our focus on valuations provides some optimism for the coming year. After years of concern about stretched price multiples, the combination of 2018’s strong earnings growth and the late-year market pullback make for more attractive fundamentals — the 12-month forward P/E for the S&P 500 is a little above 15x, well below its five-year average. We think there’s room for the P/E multiple to expand in 2019 as share prices catch up to revenue and earnings gains.
After dwelling among the worst performers for most of 2018, long-dated Treasuries rallied late in the year. Several factors fueled the bond price jump, among them a safe-haven rush away from gyrating stocks and a Fed signal that interest rates may be close to neutral.
Expectations of Treasury yields going nowhere but up appear to be dashed for now — fewer rate moves by the Fed in 2019 looks likely given mounting worries about slower economic growth ahead. This could support Treasury prices.
Prospects of slower GDP growth, stock-market strife and high debt loads are weighing on corporate bonds, and this will likely continue in the coming year. Of particular concern: BBB bonds, the lowest IG rating, now comprise close to half of the market (Figure 2). Any downgrades could be to high-yield status. We are now more focused on quality, as we see less compensation for taking more credit risk.
It’s hard to get too excited about non-U.S. developed markets when looking at the near term — gone is the promising period of synchronized global growth, which petered out in early 2018. Japan fell off most abruptly, reflecting its heavy reliance on supply chains imperiled by the U.S.-China trade dispute. In Germany, the economic engine of Europe, exports are down and so is consumer confidence.
Europe’s political environment is also challenging, which makes it all the more surprising that we’re seeing opportunity in Britain in the form of attractive valuations and strong earnings growth. How long this opportunity lasts will be to a large extent dependent on how the Brexit issue is settled.
Developed markets are significantly undervalued compared to the U.S. — the forward P/E ratio for DM is now about 1.5 standard deviations below the long-term average (Figure 3). Earnings growth for the two asset classes is expected to be more comparable in 2019, which could enhance the appeal of the undervalued DM shares.
Long before the U.S.-China trade issue developed into a leading threat to global growth, the threats and counterthreats out of Washington and Beijing (along with Fed tightening) were exacting a harsh toll on emerging markets. In early April, EM was the top-performing equity asset class — by June, it was by far the worst.
This sensitivity to trade disruption affecting China works the other way as well — the late-year progress toward a deal provided more lift for EM than other markets, an indication that more upside may lie ahead in 2019 if the trade issue is settled, the Fed slow-walks rates and the U.S. dollar continues to level off.
Already we’re seeing a bit more optimism out of EM that economic conditions are improving (Figure 4). With U.S. GDP growth expected to dip in 2019, the 6+% growth envisioned from China, India and across much of Asia looks all the better. In our view, EM remains a long-term relative valuation opportunity that could provide a bumpy ride over the short term.
As with other asset classes, the outlook for commodities hinges to a large extent on Federal Reserve policy moves and the U.S.-China trade conflict.
A Fed less aggressive on interest rates in 2019 stands to be demand-positive for oil and other commodities priced in dollars, as rising rates have been a key dollar driver. But oil producers also have a persistent oversupply problem — even with the latest agreement by OPEC, Russia and others to cut output, an ongoing glut is forecast for 2019.
China is the world’s leading market for industrial metals and a major importer of oil and agricultural products, so economic slowing in China due to U.S. trade impediments have presented headwinds for these commodities. We would expect this to continue into the coming year, at least until any trade deal is reached.
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