by David Munn, CFP
As the ball dropped in Times Square on New Year’s Eve, many investors likely breathed a collective sigh of relief that 2018 had come to an end. A year that started with a strong surge for stocks ended with the worst December since the Great Depression1, resulting in the worst calendar year since the Great Recession crash of 20082. In the following commentary, Paul Hoffmeister, Chief Economist for Camelot Portfolios, analyzes the factors that caused the markets to behave how they did, and looks ahead to what 2019 might hold.
Summary:
The primary macro variables driving equities in 2018 appeared to be the Fed and US-China trade. Positive news in both during 2019 are likely to spark a strong rally.
Market volatility and seemingly abrupt weakness in US manufacturing will likely cause the Fed to raise the funds rate once this year, if at all. Meanwhile, political and economic pressure should cause President Trump and Xi to reach a partial trade deal.
During Q4 2018, the S&P 500 Index declined 14.0% (not including dividends). Prior to the last quarter, the S&P 500 has experienced 16 quarters since 1970 in which the index has declined 10% or more. The average return in the S&P 500 four quarters later was 16.1% (not including dividends). In only four instances did the S&P 500 suffer a negative return 4 quarters later.
For us to become worried about an approaching recession, we need to see US manufacturing and employment conditions worsen significantly more.
When we look back at the ups and downs of the stock market in 2018, three things are apparent to us: 1) the two primary macro variables moving equities last year were the Fed and US-China trade; 2) nervousness about aggressive Fed policy led to the two 2 major market selloffs (in February, and then between October and December); and 3) positive and negative news in US-China trade negotiations led to a lot of the intervening market volatility.
As 2018 closes, we believe that market participants have heavily discounted for excessively aggressive Fed policy in 2019 and, at best, a 50/50 probability of Presidents Trump and Xi reaching a trade deal. This suggests that positive news from both variables – such as no rate increases in 2019 and at least a partial US-China trade deal – will ignite stocks.
As we assess the monetary and trade variables today, we’re seeing encouraging signs, leading us to believe that the worst is over for equities during the near-term and that 2019 will see a strong rally.
First, Fed officials appear to have been caught off guard and worried about the significant stock market weakness following the December 19 FOMC meeting where the Committee telegraphed a policy trajectory wildly out of line with market expectations.3 The Committee collectively expected two more quarter point rate increases in 2019, whereas the futures market is currently expecting not even a single rate hike.4 The ensuing stock market selloff appeared to have led New York Fed President John Williams to go on CNBC on December 21 in order to soothe markets. He indicated that Fed rate forecasts in 2019 were not promises, and the Fed will adjust if necessary.5 Willliams said, “We’re going to go into the new year with eyes wide open, willing to read the data, listen to what we’re hearing, reassess our economic outlook and take the right policy decisions that will keep this economy strong.”6
The manufacturing surveys of the last month are showing, in our view, that the slowing housing market and declining oil prices are creating stresses in key segments of the economy. Furthermore, and perhaps more importantly, the specter of aggressive Fed policy that seeks to limit growth, which has been omnipresent since February and especially pronounced since October, is arguably restraining economic activity and risk taking more than many appreciate.
In sum, as we assess the weakening economic data and the apparent concern on John Williams’ part over the recent market panic, we expect Fed policy to shift decisively dovish in 2019. And if monetary policy is the most important macro variable today, as it seemed to be in 2018, then it should hold that the indications of such a shift will spark a strong equity market recovery.
There are also encouraging signs in the US-China trade variable. On December 29, President Trump announced via Twitter that he had a “long and very good call” with President Xi, and that a “deal is moving along very well!”7 We continue to be more optimistic than many that at least a partial trade deal will be reached, as the pressure seems to be severe on both leaders to strike a deal.
Of the myriad risks and uncertainties around the world, and their potential impact on markets, we are especially concerned that markets could react negatively to political instability in the United States, stemming from the Mueller investigation.
Our base case for equity markets in 2019, however, is that this scenario will be avoided. It is probably most likely that the Mueller investigation will inflame both parties in Washington, but ultimately, given the rebuke Republicans received in the 2018 midterms, Democrats will avoid impeachment proceedings and let voters decide President Trump’s fate in the 2020 election cycle.
Meanwhile, we expect the Fed will back off its rate-hiking cycle and raise the funds rate only once in 2019, if at all; and Presidents Trump and Xi will reach a partial US-China trade deal.
2. https://www.cnbc.com/2018/12/31/stock-market-wall-street-stocks-eye-us-china-trade-talks.html
3. “Why 2019 Could Be Very Good Year for Stocks, After Worst Year in Decade,” by Patti Domm, December 31, 2018, CNBC.
4. Ibid.
5. “Fed Official Tries to Soothe Nervous Investors,” by Binyamin Appelbaum, December 21, 2018, New York Times.
6. Ibid.
7. “Trump Hails Call with China’s Xi, Says Trade Talks Are Making Good Progress,” December 29, 2018, Reuters.
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