January Investment Comments
Investors hoping for a year-end rally have instead been treated to increased market volatility. A near 5% decline in its first week was the market’s worst start to December since 2008, though this drop followed what was the S&P 500’s best week in almost seven years. The recent turbulence is reflective of an environment where both market bulls and bears have valid arguments to support their stance.
Topping the list of current concerns is the U.S.-Chinese trade dispute. The market initially celebrated what appeared to be a positive meeting between President Trump and Chinese President Xi Jinping following the G20 summit. This meeting resulted in a 90-day postponement in tariffs on $200 billion in Chinese imports that were expected to jump from 10% to 25% at the start of the year. However, the initial positive interpretation of the meeting was subsequently brought into question given reports of “significant differences” in the two governments’ versions of what was agreed upon at the dinner. Markets also did not respond favorably to President Trump’s tweet days after the meeting proclaiming himself a “Tariff Man.”
Tensions rose following the arrest in Canada of the chief financial officer of Chinese telecom giant Huawei Technologies at the request of authorities in the U.S. Meng Wanzhou was arrested on suspicion of lying to U.S. banks to circumvent U.S. sanctions on Iran. China warned of “serious consequences” should Canadian authorities fail to release her. The arrest resulted in some concern it could disrupt the trade truce, though President Trump has come out and said he would intervene in the case if that would help secure a trade deal with China.
Next on the list of concerns is the current course of tightening by the Federal Reserve. Chairman Powell rattled markets in October when he indicated his belief the Fed remains “a long way from neutral,” implying several more rate hikes were on the way. The neutral rate is the level of interest rates that neither speeds up nor slows down growth and is generally viewed as a Fed Funds rate 0.75%-1.0% over the rate of inflation. Given recent inflation readings of approximately 2%, this would imply a neutral rate of 2.75%-3.0% versus a current Fed Funds rate of 2.0%-2.25%. In reality, this is a simplification and the true neutral rate is very difficult to pin down, though markets were surprised Powell deemed the neutral rate far off. More recently, Powell took a different view, saying interest rates remain “just below” what would be neutral for the economy. This was a noteworthy change that was well-received by markets.
Though slightly weaker than expected, the November employment report was solid enough to keep the Federal Reserve on track to raise interest rates at its December meeting. Employers added 155,000 jobs in November. Average monthly job gains over the past three months is down to 170,000 versus 209,000 for the prior 12 months, though still well above the 100,000 jobs per month economists believe is needed to keep up with population growth. The unemployment rate held steady at 3.7% and wages increased 3.1% versus a year ago, both generally within expectations.
Markets anticipate a 0.25% increase in the Fed Funds target rate at the December meeting, though expectations for rate increases next year have come down in recent months. The Fed indicated an expectation from the last dot plot release in September for three rate hikes in 2019, with the market anticipating two rate increases. Fed-funds futures currently imply less than a 50% chance the Fed raises rates more than once next year.
Just over a year ago the Fed began to shrink its balance sheet, which had grown to over $4.0 trillion from approximately $800 billion prior to the financial crisis. The amount of Treasury and MBS holdings the Fed is allowing to mature without reinvesting has been increasing according to a predetermined schedule and achieved its maximum runoff of $50 billion per month in October. The ECB also plans to end its nearly $3 trillion bond purchase plan this month. These programs provided liquidity that is now being pulled back. How the markets react is something of an unknown as we are in uncharted territory.
The flattening yield curve continues to attract attention as the Fed continues its path of rate increases, which boosts short term interest rates, while concerns about slowing growth have held down rates at the longer end of the curve. The difference between the 10-year yield and 2-year yield has dropped to its lowest level since 2007. This is closely monitored because when 2-year yields exceed 10-year yields it has served as an indicator of a potential recession. There are various reasons why an inverted yield curve would be a less reliable indicator of recession in the current environment than it has been historically, though an inversion would certainly weigh on sentiment.
Listing the current concerns makes it sound as if the backdrop tilts toward the unfavorable, but the reality is there are always concerns one can list regarding the market. There are also plenty of positives to carry us into the new year. Growth has been strong this year, with GDP growing at a 4.2% rate in Q2 and a 3.5% rate in Q3. The Atlanta Fed’s GDP Now estimate for Q4 is 2.4%. Growth is slowing, but these are still solid numbers, and expectations for 2019 are for growth in the 2% range.
If a recession is around the corner, it is hard to see. A day after the November jobs report was released, Chairman Powell highlighted the economy is “currently performing very well overall, with strong job creation and gradually rising wages.” Even if growth slows, the U.S. economy is durable, and it would be challenging to dip into a recession with the unemployment rate where it is today. It appears the market needs to digest slower growth, but it is important to underline growth is still expected over the next year. Q4 earnings are expected to grow over 13%, bringing full-year earnings growth over 20%. For 2019, expectations are for revenue growth of over 5% and earnings growth of more than 8%. The current forward P/E is a relatively undemanding 15.5x.
The market may rally into year end. However, short-term forecasts are something that few, if any, are able to get consistently correct. Neither are they the foundation for a sound long-term investment plan. In turbulent markets, having a long-term strategy in place and sticking with it is the key. Owning quality, growing companies trading at reasonable-to-attractive valuations is the best recipe for long-term success.
James M. Skubik, CFA