- The U.S. and China agreed to a trade ceasefire, but tensions remain elevated.
- Stock prices have been more volatile since fourth quarter 2018 began.
- Market sentiment is decidedly more negative, and “caution” is the prevailing sentiment.
- Global growth is likely to slow in 2019, but remain positive.
- Tariffs and a potential Fed policy “mistake” are the two largest threats to the U.S. economy.
- Investors should emphasize high-quality investments in their portfolios.
Data Source: FactSet
The markets downshift into year-end
Markets have remained turbulent in recent weeks despite some apparent easing of concerns over the pace of Federal Reserve (Fed) interest rate hikes. The ongoing trade dispute between the U.S. and China, however, has seen mixed results and thus continues to act as an overhang on investor sentiment.
Following the G20 summit in Argentina earlier this month, the U.S. and China agreed to a 90-day trade ceasefire. The temporary cooling-off period is designed to allow both sides more time for negotiations as they strive to reach a formal and lasting trade agreement. However, the devil is still in the details. Importantly, the U.S. is looking for substantial changes in Chinese economic policies, particularly on how Beijing treats U.S. businesses and how it competes globally. Changing how China respects and views intellectual property and technology are key items the U.S. is looking to influence through trade discussions. Such policies could prove very difficult to change over such a short window. As such, investors appear to view the trade ceasefire with a degree of skepticism.
Additionally, the threat of slower growth, prompted by rising interest rates, may have been reduced over recent weeks. Comments from the Federal Reserve provided indications that it may be able to limit interest rate hikes going forward, a pronouncement that was favorably viewed by the markets. This could give the market and economy some much-needed breathing room heading into the new year.
Investor sentiment shifts
We expected the Fed’s interest rate stance and the temporary calming of trade tensions to have a positive influence on stock prices. Based on recent performance, however, investors are clearly heading into 2019 with a cautious attitude.
Since selling pressure began in October, the S&P 500 Index® has failed to stay above a price level of 2800 (the Index ended November at 2760). Also, the S&P 500 has moved above its longer-term trading average three times since October only to fall back below the key trend line. For investors, these technical signals indicate potential market weakness. Recent catalysts on trade and interest rates have done little to shake investors from their “sell first, ask questions later” approach, which has dominated market direction since the fourth quarter began.
With the year coming to a close, investors find themselves in a far different environment compared to how the year started. Optimism about accelerating growth across the globe, lower U.S. taxes, and a business-friendly environment that were prevalent early in 2018 have given way to fears that tariffs and higher interest rates could eventually stall growth, potentially leading to a recession. While we do not believe a recession is in the cards for 2019, the truth in these opposing views could fall somewhere in the middle.
A time to focus on quality
Despite our expectations for a downshift in global growth next year, U.S. fundamental conditions remain positive. We expect S&P 500 earnings growth to slow, but profits could still grow by as much as 5% to 8%. Such earnings growth would be in line with longer-term averages for large-cap U.S. stocks. Conversely, with stock prices now trading at attractive valuations compared to historical averages, we believe recent price weakness offers a better entry point for longer-term investors willing to stomach the near-term uncertainty.
Nevertheless, the investment environment next year could prove very challenging and volatile. Investors should use the recent weakness in markets as an opportunity to strengthen their exposure to higher quality investments. For equities, we believe that includes increasing exposure to companies with predictable earnings streams, strong balance sheets, and competitive advantages. For fixed income, that means increasing portfolio exposure to higher-quality debt instruments and resisting the desire to stretch for yield in below investment-grade debt at this point in the cycle.
Data source: Morningstar Direct
As of December 13, 2018