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As 2019 unfolds, three themes seem set to drive US market sentiment and returns.
1. The Fed’s Rate-Hike Cycle is Nearly Complete
The Fed has already raised rates nine times in this cycle, starting in December 2015. Our expectation is that the Fed will likely raise rates one or two times in 2019, and then perhaps pause to assess the economic data and impact. The market expectation for 2019 is currently for one more rate hike, while the last set of Fed median estimates indicates three more rate hikes in 2019.
Regardless of which camp is correct, the key point in our view is that the Fed’s cycle is close to the end: nine rate hikes have been completed, and there may be between one and four left. As a result, the majority of the market’s adjustments are behind us.
2. A Global Slowdown Has Begun; the World Is Now on US Recession Watch
The global economy has shown clear signals of slowing, with Bloomberg forecasts putting 2019 global GDP growth at 3.6 percent, down from 3.8 percent in 2018; similarly, developed-market growth is predicted to fall from 2.4 percent to 2.1 percent. In the US, we expect GDP to decelerate to less than 2.0 percent by the fourth quarter of 2019.
As we move through next year, keep in mind the confluence of factors that, working together, may create headwinds for the US economy:
• The fading impact of fiscal stimulus and tax reform, which will have anniversaries in the first quarter of 2019
• The headwinds to global corporations stemming from a strong US dollar in 2018
• Higher wages and material costs pressuring margins
• A slowing global economy, from which it may become harder to decouple as fiscal stimulus fades
While our base case for 2019 does not call for a recession in the US— in fact, our recessionary indicators generally still seem relatively healthy—we and the rest of the world will carefully assess the impact of the Fed’s rate hikes, particularly on the US Treasury yield curves and the US credit markets. These could be leading indicators of an impending US slowdown.
3. Black Swans Abound
Just like in 2018, several unknown factors—“black swans”—could spark market volatility in 2019. These include ongoing trade negotiations, elevated oil price volatility, geopolitical tensions, worries about US corporate leverage and concerns about rate-sensitive portions of the economy—such as housing and autos.
On the subject of trade, US President Donald Trump’s recent meeting with Chinese President Xi Jinping at the G-20 summit resulted in a seemingly positive step towards a trade resolution. Although we have already seen volatility around the timeline and goals of these trade talks, we believe that both parties have a vested interest—both from an economic and financial-markets perspective—to come to a trade resolution.
While there is certainly potential for negative risks to emerge in 2019, there could also be upside surprises in the US economy—in addition to trade progress.
• We could see elevated consumer and small-business confidence: lower oil prices and a stronger dollar are both supportive of the US consumer, and consumption is a key driver of US GDP.
• And as President Trump’s focus shifts towards the2020 presidential elections, he may work rigorously to avoid having the US economy slip into recession. This could result in additional legislation or stimulus, enacted unilaterally or with the support of Congress, which could be positive for the economy.
Expect another Modest Year In 2019
All in all, we expect 2019 to be another year of modest returns and elevated volatility in US markets. Using our own 2019 earnings-growth expectation of 5-7 pecent, with limited further multiple compression, we anticipate a low-single-digit return for the S&P in 2019. Add to this an average dividend yield of approximately 1.8 percent, and total returns could reach mid- to high single-digit territory. This would still be attractive compared with many other asset classes.
We also expect volatility to remain elevated in 2019. Investors should be prepared for similar choppiness as we get closer to the end of the Fed tightening cycle and as US recession watchers remain on high alert.
Portfolio positioning: Four to watch
We continue to believe that equities generally offer the highest potential as an asset class, but we still favor a generally more-defensive positioning across portfolio allocations.
1. US Equities
We believe investors would be prudent to focus on higher quality while applying a barbell approach to sector positioning. We still are looking to participate in the long-term investment theme we call “winners from disruption”—including areas like cloud computing, cyber-security and electronic payments. But we believe investors should balance these with defensive sectors like healthcare and consumer staples, which can hold up even in a slowing economy. We generally prefer investing with companies with strong balance sheets and free cash-flow metrics at this point in the cycle, since they can better withstand rising rates and a decelerating economy.
2. Global Investments
We also see another barbell forming from a global perspective. We view China and emerging markets as offering more potential upside for investors, particularly if the US dollar stabilizes or weakens in 2019, and if we get a meaningful resolution on trade. The other end of this global barbell remains the US, as its economy will continue to be a relative outperformer in the developed world. In our view, Europe remains uncertain, and until we get more clarity around Brexit and the situation in Italy, it may be difficult to find incremental returns in this region. However, valuations have become more attractive and, notably, Europe may ultimately provide an important source of yield.
3. US Fixed Income
We are positive on shorter-duration fixed income and incrementally more cautious on high yield; we believe active management is critical for this space. We also believe convertible bonds could benefit from elevated volatility. We remain comfortable with an allocation to US treasuries, which remains a flight-to-safety asset class and can be a good place to tactically park assets while awaiting market opportunities.
As we get later cycle in the US economy, we believe there should be more room for alternative assets in an investor’s portfolio. This may come in the form of private equity or credit, as well as areas like infrastructure debt and equity. Both remain less correlated to both public equities and fixed income, and as a result offer a good source of potential portfolio diversification.