By Brian Herscovici, CFA
Chief Investment Officer, USAA Managed Portfolios
Worries about slowing global growth, rising interest rates and trade turmoil pummeled risk assets around the world. A frantic fourth-quarter selloff for U.S. large caps more than erased what had been a double-digit gain through the first nine months of 2018. The S&P 500’s full-year total return was negative for the first time in a decade.
Safety-minded investors piled into long-dated Treasuries late in 2018, pushing up prices and pulling down yields. At year-end, the 1-year bill offered essentially the same yield as the 10-year. Credit spreads for investment-grade corporate bonds widened on greater concern about downgrade risk given high debt loads and an economic slowdown.
It’s always tough to forecast what a new year might bring for markets. Trying to peer ahead is proving more difficult than usual, given what we’ve been seeing over the past few months. As a result, we begin 2019 on the cautious side.
Wild day-to-day swings for stocks, a sharp drop in Treasury yields, plummeting oil prices and an upward spike for gold – these trends reflect concerns about a slowing global economy. We think an even bigger contributor to recent instability is erratic words and actions from national leaders and other influential sources. As the well-worn saying goes, “markets hate uncertainty.” Perhaps even more, “markets hate inconsistency.”
Exhibit A for inconsistency is the Federal Reserve. Investors lately have had trouble getting a coherent story on the Fed’s interest-rate intentions. Jerome Powell, the chairman, was publicly hawkish about monetary tightening, then he was dovish, then he was more hawkish again – all in a mere six weeks. It’s not hard to see why these gyrations kicked up anxiety levels in an already nervous market.
Then there’s political uncertainty and inconsistency. In the U.S., any progress made on settling the trade standoff with China seems to quickly evaporate and a last-minute deal to avert a partial government shutdown didn’t survive a single news cycle. Europe, meanwhile, faces growing separatist movements and yellow-vested resistance to reforms while its economy struggles for traction.
Contrast to Europe and China, economic conditions in the U.S. look pretty good now. The economy is growing at a nice clip and job creation remains strong. Wages are rising, and overall inflation is mild. The consumer is still spending freely and, while corporate earnings growth is off its recent peak, it’s still solid. Markets tend to be forward-looking, however, which explains why they are so hung up on certainty and consistency.
The worry is that the key uncertainties – interest rates, trade turmoil, tense politics – will cause the U.S. economy to stumble in 2019. The gloomiest cohort of market watchers envision more than a stumble – they are readying for recession.
They point to the near-flat Treasury yield curve to support their view, as a flattening curve often leads to an inverted curve in which shorter-maturity bonds offer higher yields than longer-dated bonds – the relationship between the 2-year and 10-year Treasuries is most closely watched. An inverted yield curve is a sign of economic pessimism, as investors sell risky stocks and seek safety in bonds. Every U.S. recession in the post-World War II era has been preceded by an inverted yield curve.
However, we don’t see the longest period of economic expansion in U.S. history ending with a recession in 2019, even though GDP growth will likely ease a bit as money gets tighter and the impact of fiscal stimulus fades. And while the yield curve has been a reliable indicator for six-plus decades, the lag between inversion and recession has been as long as two years.
Of course, we would have to revisit our cautious but measured outlook if global trade completely unravels or the Fed and other major central banks go hard on monetary tightening. Fear is running high in the markets as 2019 begins, so there’s but a slender margin of error for politicians and policymakers to avoid setting off an investor stampede for the exits.
Tactical positioning for USAA Managed Portfolios (UMP) at the end of 2018 favored U.S. equities relative to emerging markets, given the stronger economic and earnings growth outlook. Within non-U.S. markets, however, we see near-term opportunities in Europe, which is attractively priced and early in its economic cycle (though political turbulence is a risk). We also maintain a tactical tilt to short-term, investment-grade credit based on appealing yields at the short end of the curve and to reduce overall risk.
Among our key asset classes, only municipal bonds (+1.3%) were able to generate positive absolute performance for full-year 2018. At the bottom end were emerging market equities, which posted double-digit negative returns. Alternative strategies helped our portfolios by providing downside protection as intended.
Our key themes heading into 2019:
U.S. EQUITIES: Just when it seemed the bull market was going to end short of a decade, along comes a “Santa Claus rally” for the S&P 500 (+7% between Christmas and New Year’s Day) to keep the record going. As discussed above, the U.S. economy faces the prospect of slower growth, but its outlook remains brighter than other corners of the world. While earnings growth in 2019 is almost certain to fall short of 2018’s stellar numbers, current projections of mid- to high-single-digit expansion in both revenue and profits can support share prices.
INTERNATIONAL DEVELOPED: Non-U.S. developed market equities were roughed up in 2018, but we still like them based on relative valuation. Also attractive is that they are earlier in the economic cycle than the U.S., and thus they may have a longer performance runway. Europe is following the U.S. model by replacing its emphasis on monetary stimulus with greater fiscal spending to promote economic growth and quell political unrest. Europe’s heavy export reliance on China is a possible weakness, especially if the U.S.-China trade dispute escalates.
U.S. CORPORATE BONDS: The likelihood of slower GDP growth and possibility of more Fed rate hikes has raised our concerns about credit. Within investment-grade, the BBB segment (the lowest IG rating) has exploded in size in recent years – it now represents nearly half of all IG debt outstanding, as companies have borrowed heavily to finance merger activity and share buybacks. The spike in new BBB debt raises downgrade worries. We have been reducing our exposure to credit within portfolios, and have focused on moving up in quality to better balance risk and potential reward.
As always, our suggestion to members is to remain focused on the long-term investment plan that you have put so much thought into. Stay invested, be diversified, and have a balanced portfolio that aligns with your risk tolerance. USAA Managed Portfolio shareholders who may be uneasy about market risk in general or have concerns about current asset-class allocations should consider consulting with a USAA advisor.
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