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2019 Market Outlook: Will Turbulent Times Continue?

2018 was the most volatile year in the investment markets since the financial crisis of 2008-09 – and 2019 seems likely to bring more of the same. But while we see challenges ahead in 2019, we also see opportunities.

Despite the recent market turbulence, the U.S. economy currently seems to be on solid footing, with rising employment, manufacturing expansion across most sectors, healthy consumer spending, and solid corporate earnings growth.image
      1

But some of the challenges that shook the markets in 2018 could continue to play a role in 2019. Here is our assessment of some of the key issues that the economy and markets may face in the next 12 months:

Rising interest rates. The Federal Reserve (Fed) has raised interest rates nine times since December 2015 from about 0.0% to a range of 2.25 - 2.50%. These rate hikes have led to higher yields on short-term bonds, which makes them a more competitive alternative to stocks. Over the past few years, historically low bond yields have given investors little reason to buy bonds. But as rates have risen, bonds and even money market fund yields have looked more attractive, particularly as market volatility emerged. Our view is that Fed policy has been prudent and necessary to this point, and that rates have reached a level that will allow the Fed to significantly decelerate its rate hike policy.

exhibit 1

After recent stock market declines, market valuation, as measured by the market’s earning yield, has become much cheaper (Exhibit 1). If further increases in short-term interest rates are limited, the earnings yield on stocks will look much more compelling than bond yields.

Flattening yield curve. Closely tied to Fed policy has been the narrowing of the interest rate differential between long and shorter maturity bonds. This “flattening” of the yield curve, as short-term rates and long-terms rates begin to converge, has led to widespread concerns of “inversion,” in which short-term rates become higher than long-term rates. While this has sometimes been a precursor to market and economic weakness, the length of time from the flattening/inversion of the yield curve and a bear market can vary greatly from one instance to another. In fact, we do not consider this a classic inversion because the flattening occurred at the very short end of the curve during a period of aggressive rate hikes by the Fed. We do not expect the flattening/inversion to continue for an extended period.

However, significantly higher short-term rates are now a benefit for more conservative savers, or for investors who would like some allocation to cash in a diversified portfolio.

Geo global issues. There are a multitude of disconcerting geopolitical events, particularly U.S.-China trade frictions and Brexit, which have injected a high degree of uncertainty and anxiety into the markets. Our view is that the outcome and ultimate impact of these developments are very hard to determine. Consequently, this uncertainty will continue to manifest itself in higher levels of volatility and more subdued stock market valuations.

Growing debt levels. The high and growing level of global debt and other liabilities by government, corporate and individual borrowers, including pension and health benefit obligations, are beginning to weigh on longer term investor perceptions. Historically low interest rates have significantly mitigated the near-term cost of servicing these liabilities. Our view is that high debt levels are indeed an issue of concern, particularly if interest rates were to rise further. Partially offsetting this concern is the fact that consumer debt has not increased to excessive levels since the last recession, and thus should not be a contributing catalyst for potential problems.

Divided U.S. politics. The new Democratic majority in the U.S. House of Representatives will likely lead to greater political discord in Washington, D.C. Will the House ramp up its investigation of the president? Will its members initiate an impeachment process, and if so, where will it lead? These are very real issues that have already been raised by House members. While the U.S. economy currently seems to be on sound footing, a lengthy, high stakes political battle of that magnitude could affect the economy and the markets.

Corporate earnings growth. Corporate earnings have been exceptionally strong due to solid economic fundamentals and the recent corporate tax cuts. However, there is some concern that peak earnings have been reached, with revenue growth poised to decline as the economy moderates. We also may see profit margins decline as employment and logistics costs escalate.

Our view is that although the positive impact from lower tax rates will fade, earnings will still be healthy by historical standards if operating margins prove resilient. Also, we see little evidence that the economy will downshift materially such that corporate revenues will stop growing.

Stock market valuations. Price-to-earnings ratios have moderated in the past few months as the stock market declined.  But we are still cautious that return expectations should be tempered. (The price-earnings ratio is a stock valuation method in which the stock price of a company is divided by its annual earnings.)

Strong employment and manufacturing. Manufacturing expansion has continued across most industries for the past 115 consecutive months. Employment has grown for nearly 100 straight months, and there continues to be a strong demand for new workers. We expect the employment picture to remain strong, as many businesses face a shortage of qualified workers.

Conclusion

While many risks continue to weigh on market returns, we believe that high and rising debt levels may be the most problematic risk from a longer-term standpoint. Given the diminished level of liquidity in the market, volatility may remain high, and further equity market declines are certainly possible.

However, we believe a healthy domestic economy, strong job market, sustained corporate earnings growth, relatively low interest rates, and more moderate valuations may counteract the rising tide of late cycle risks. But we continue to believe that long term returns will be muted as compared to the very strong returns over the past several years.

Finally, in periods such as this, it is important for investors to assess their real risk temperament relative to the time frame of their investment objectives and to ensure that their overall portfolios remain properly balanced and diversified across asset classes.

See 2018 Market Recap: Rocky Year Ends with Rollercoaster December

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