Marco Fragnito | Managing Principal
- We at MCF enter 2019 the most bullish we have been in the last six months as we expect monetary and economic conditions to improve.
- Despite witnessing a market decline in the final quarter which recorded the largest December decline in market indexes since the Great Depression, we remain bullish in light of positive data trends.
- In 2018 we saw GDP growth of over 4% for the second quarter and we expect growth to continue.
- Potential shift in Federal Reserve Monetary Policy from tightening to accommodative is encouraging for the direction of interest rates.
- Hot Topics in 2019: Interest Rates, US-China Trade Relations and Domestic Political Uncertainty.
December 2018 Review
The final month of 2018 in financial markets saw large price declines and a continued increase in volatility. The Dow Jones Industrial Average saw a decline of 8.7%, while the S&P and the NASDAQ Composite respectively lost 9.2% and 9.5%. These represent the largest declines in the equity market averages in December since the Great Depression. With equities continuing their decline perceived “safe haven” investments such as US Treasuries and gold rallied. A remarkable development when one considers the positive economic numbers that continue to be reported.
What are financial markets trying to tell us? Are markets experiencing a short-term crisis of confidence? The answer, only time will tell. Several concerns continue to persist, from a slowdown in global growth, ongoing trade disputes, declining oil prices, political uncertainty, and our most significant concern–US monetary policy being far too tight.
With markets already in decline, the statement following the Federal Reserve’s Federal Open Market Committee (FOMC) meeting combined with Fed Chairman Jerome Powell’s press conference further soured sentiment with what was perceived to be a much more “hawkish” tone than expected by markets. This led to market averages falling into bear market territory at different times over the course of December, a development not seen since the Great Recession and financial crisis of 2008-2009. Equity markets entered 2019 on the defensive with market participants extremely concerned.
The rally in fixed income markets continued as investors sought “safe haven” assets in the face of declining equity markets. US Treasuries experienced their best month since 2016, with yields dropping across the curve. The yield curve continued to flatten and saw some inversion, with the yield on one-year T-Bill trading higher than yields all the way out to the seven-year notes. The yield on two-year note saw its largest decline since November 2008, while the spread between ten- and two-year notes narrowed to the lowest level seen since 2007. All of this led to investors beginning to discount that a recession was just around the corner, we are not in that camp, but we do expect the economy to continue to slow down.
In the commodity sector we saw gold continue to rally on its “safe haven” asset status, the much larger news however was the continued steep decline in oil prices. West Texas Intermediate (WTI) crude oil prices declined a further 11% in December, for a total decline of almost 36% since early October, further reinforcing market perceptions of a weakening global economy. This also led to heightened concerns related to the high yield debt market where oil companies represented a large portion of the new issuers of debt over the last few years.
In 2018 volatility returned to financial markets and equity investors experienced their worst losses since the 2008 Financial Crisis. Although the declines where modest (6.2% for the S&P 500, 5.6% for Dow Jones Industrial Average and 3.9% for NASDAQ Composite) in comparison to those experienced in the last decade which saw equities lose over 20% of their value in 2002 and 2008. Following a strong 2017, investors entered 2018 feeling confident about the economy and markets, and for most of the year, their sentiments were justified. With strong domestic growth which saw GDP increase at a rate of 4.2% for the second quarter, combined with continued global growth equity markets hit new all-time highs in September. The path to those new highs proved at times challenging for markets.
Markets began the year strongly and raced to new highs in January only to be upended in early February when the jobs report saw US wage growth rise by 2.9%, the fastest pace in a decade stoking inflation fears and fears of a faster pace of interest rate increases by the Federal Reserve. The Dow and S&P 500 quickly lost over 10% of their value for the first time since early 2016, while bond yields rose to their highest levels in years.
After a brief recovery, markets were further negatively impacted when President Trump announced tariffs on imported steel and aluminum in the early part of March. This was followed with the US announcing further tariffs on another $60 billion dollars of Chinese imports later in the month, with more to come later in the summer. As we entered the second quarter investors’ attention returned to focusing on strong corporate earnings, continued strong economic growth and a realization that the US negotiating position on trade was stronger than first anticipated. This began a slow steady rise in equity markets to new highs by the end of summer, with volatility receding both in the stock market and fixed income markets. This all changed once we entered the third quarter.
While a rise in inflation did occur in 2018, it remained well contained and for most of the year below the Fed’s target of 2%. This did not stop the Federal Reserve from raising the Fed funds rate 4 times from a target of 1.25-1.5% to 2.25-2.5%. Economic readings were in fact strong. For example, the unemployment rate was at a half-century low of 3.7%, the JOLTS survey was positive, PMI reached its highest level since 2004, the service sector expanded at the fastest pace since 1997, and finally GDP increased by 4.2%. This may have justified rate hikes, but it is our opinion that subdued inflation readings offered an opportunity for the Fed to raise interest rates at a slower pace.
October 3rd started a roller coaster ride for markets that would last until year end. On that day, a week after the FOMC voted to raise interest rates for a third time, Fed Chairman Jerome Powell spoke of a “remarkable positive outlook” for the US economy, suggesting the country was in the midst of a “historically rare” era of very low unemployment and low inflation. In the same speech, Chairman Powell stated however that interest rates were “a long way from neutral,” which markets interpreted to mean interest rates would rise faster and farther than anticipated, and with that the turmoil began. In the next 2 months we saw volatility rise across financial markets and equity indexes drop over 10% from their all-time highs.
Markets staged somewhat of a recovering after in a late November after Chairman Powell softened his comments by saying that interest rates were “just below” neutral. Additionally, the positive meeting between President Trump and China’s Premier Xi at the G-20 summit in Buenos Aires also provided support for global equity markets. This proved short lived. As investor focus shifted back to the political uncertainty created by the mid-term elections in the US, the lack of a Brexit deal in Europe, a housing slowdown, no resolution in trade disputes and all indications that interest rates would be raised again in December. With the Fed raising rates for a fourth time on December 19, equity markets sold off into bear market territory over the next week. “Safe haven” investments such as US Treasuries and gold rallied into year-end, with gold being one of the few assets to post positive returns for all of 2018.
By year-end most equity markets worldwide suffered even larger declines than our domestic indexes. Some notable declines were in China where the Shanghai Composite lost 24.6%, the German Dax lost 18.3% and the Japanese Nikkei Index lost 12.1%. Commodity markets fared no better with the Bloomberg Commodity Index losing 13% while WTI Crude oil lost 24.8% for all of 2018. Fixed income markets also experienced dismal performances with investment grade corporate bonds, as measured by the Bloomberg Barclays US Corporate Bond Index, delivering their worst annual return (-2.5%) in a decade in 2018.
2019 Market Outlook
Before attempting to articulate a market outlook for the coming year, we at MCF Capital Management like to see how the previous year ends and how the new one begins. The reason for this is that trading data collected at the turn of the new year has usually proven to be very insightful as to the direction of equity markets for the year. This year even more so as several Federal Reserve members and most importantly the Fed Chairman himself were set to deliver important speeches. Their speeches undoubtedly proved to be market moving and set the tone for our 2019 market outlook.
In my 35 years of being in the investment management business, I have never seen anyone be consistently right when it comes to forecasting on the US economy. With the US GDP approaching $22 trillion it seems almost impossible to do so. We would rather focus on looking at what the consensus is in the areas of economic growth, unemployment rates, inflation, corporate earnings and things such as oil prices. Based on market consensus we attempt to ascertain whether we agree or disagree with market expectations. This provides us with a guideline in helping determine our asset allocation for the upcoming year. As for sector selection we remain committed to being invested in the leading long-term investment trends.
General market consensus forecasts for major economic statistics center around the following estimates for 2019:
- GDP Growth of 2.5%
- Unemployment Rate of 3.4%
- Core Inflation Rate of 2.5%
- Federal Fund Rate 3.0%
- S&P Earnings Forecasts $160 to $190
- WTI Crude Oil Forecasts $60 to $70.
We would agree with the GDP growth consensus of 2.5% with the bulk of it occurring in the second half of the year. We disagree with the consensus for unemployment, due to the participation rate continuing to rise throughout the year. We also disagree with the inflation rate consensus and expect the rate to be much closer to the Fed’s 2.0% target and potentially lower. With our expectations for lower inflation we would disagree with the consensus level for the Fed Funds rate and expect rates to remain flat and we could potentially see a rate cut sometime in the third or fourth quarter.
The S&P earnings forecast range is wide but would seem appropriate given wide dispersion for economic growth. We prefer to focus on the price earnings multiple afforded earnings, we would expect price to earnings multiple to rise over the course of 2019. Presently the market P/E stands between 14 to 15 times earnings. We do agree that crude oil prices should rise in 2019 and should average somewhere between $60 to $70.
In equity markets, based on our expectations versus the general economic consensus and expectations for single digit rise in equity markets, we are decidedly more bullish than the consensus. We enter 2019 the most bullish we have been in the last six months and expect markets to deliver double digit returns with the potential for upside surprises. The following are the reasons for our above bullish consensus:
- Market valuations below the historically norm (present P/E at 14x vs. historical 16X)
- Short Term interest rates have peaked and look flat to lower
- U.S. economy avoids recession while global growth bottoms in 2019 and begins to rise
- Political uncertainty declines both domestically and internationally
- Earnings continue to grow in 2019.
The risks to our expectations for 2019 remain very much as they have been for approximately the last year, with interest rates being at the top of that list. Should the Fed’s actions not follow their rhetoric, markets will be quite vulnerable to not alone a return to their recent lows, but potentially much lower. We are also watching for a couple of risks, including an implosion of the Chinese economy and/or the impeachment of President Trump. Although we attach a very low probability to either event materializing, should either become a reality, they would pose significant risks to our expectations and global financial markets for 2019.
In the fixed income markets, we enter 2019 much less negative than we were for most of the last year. We still do not expect fixed income markets to provided attractive returns over the intermediate and long term. We believe bond alternatives in the fixed income area will offer much more attractive returns than investment grade bonds or US Treasuries. We would expect that should the Fed hold off on further rate increases and inflation remain contained at their stated target goal of 2%, we would expect the yield curve to normalize. Providing the opportunity to earn the yield on short term bonds, while longer term bonds experience slight loses as the year progresses. With the Fed’s recent change of heart, there do exist several interesting opportunities in the fixed income market which we are willing to talk to you about that did not exist in 2018.
In summary, we expect equity markets to perform well in 2019, potentially delivering double digit returns. While our asset allocation remains in a defensive posture in our managed portfolio’s, we expect monetary and economic conditions to improve enough allowing us to get more fully invested over the next few months. In addition to these factors, the resolution of several trade disputes and more clarity on the political front could lead to the start of a new bull market at home. This would help restore confidence amongst investors and bring about a new bull market which could continue well into the new decade. In fixed income markets investors will have to be nimble and seek out the selective opportunities that exist. Ultimately the bear market that began in long term US Treasuries in 2016 will be with us for several years to come.
We wish you the very best and a prosperous 2019!
Wells Fargo Investment Institute, “2019 Outlook: The End of Easy” December 2018 and “Refining Our 2019 Outlook and Targets” January 10, 2019. Wells Fargo Advisors, Angela Shin, “Monthly Market Commentary” January 3, 2019. Wells Fargo Adivsors, Dan Wanstreet, Angela Shin, David Furst, “2018: Annual Commentary” January 7, 2019.FXSTREET, Ross J Burland, “WTI en-route for the 23.6% Fibo retracement of Sep decline” January 7, 2019. CNBC, “US Crude ends the week down 11% for its worst performance since January 2016” December 21, 2018. NYU Stern, Aswath Damodaran, “S&P Earnings: 1960-Current” January 5, 2019.
The opinions expressed here reflect the judgement of the author as of this date and are subject to change without notice. Information presented here is for informational purposes only and does not intend to make an offer, solicitation, or recommendation for the sale or purchase of any product, security, or investment strategy. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here. The information being provided is strictly as a courtesy.