Chief Investment Strategist and Chief Economist
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We continue to see the recent market sell-off as an overreaction and believe it may have created opportunities for investors
A ninth interest rate hike and Fed Chairman Powell’s “automatic pilot” comment on December 19 came at a fragile time for financial markets, irrespective of the awkward year-end timing. (Prior to this current cycle, Fed rate hikes in December were historically rare).
The sharp rebound in asset prices in the early days of 2019 does much to confirm our view that an unwillingness of many investors to participate in holiday-thinned markets drove significant price dislocations.
Prior to late December, the drop in world equities already exceeded any immediate signs of slowing in economic growth. While only the future matters in setting asset prices, this ‘disconnect’ between the pace of recent growth and asset price movements means expectations have fallen for the future. Thus, growth worries could more easily be assuaged if the feared collapse fails to materialize.
With the US earnings reporting season just ahead, most observers can see estimates that imply a seemingly plausible growth rate slowdown looking at the year-to-year forecast EPS changes (+13% vs. +26% in 3Q). Less well understood, these EPS level estimates show an outright profit decline for 4Q2018 through the first quarter of 2019. While the most reliable data suggest some slowing, there was no comparable drop in economic indicators for the quarter past to suggest such a severe loss of momentum.
Following nine US rate hikes, a year of Quantitative Tightening, and fading tax cut benefits, US growth will indeed slow in 2019. Half of US manufacturing sector survey participants called out a negative impact from tariffs in the venerable Institute for Supply Management report at year-end 2018. In China’s economy, monetary and fiscal policy is easing, but the near-term indicators are likely to show a greater headwind for the trade sector ahead. This was because trade activity was boosted to precede a rise in US tariffs.
These economic disruptions create pressures for the US and China to come to terms in the next few months. While an evolving long-term issue, a trade deal might at last provide a meaningful catalyst for growth optimism after political and idiosyncratic issues created an exaggerated sense of economic risk.
The backdrop we describe has left economically sensitive equities such as transportation, industrial shares and many others weaker than they would be, and likely to rebound. However, asset price weakness on a growth scare and a ‘fresh new growth cycle’ are very different things. The slack resources of a depressed US economy a decade ago are not there to drive another decade of US growth like the one just passed.
There is now a good deal of speculation that the Fed has ‘learned’ from the recent episode and the monetary policy outlook for the US has changed materially. This would seem only partially correct. The Fed is indeed likely to pause interest rate hikes to assess economic performance in the coming quarter, including the impact of political risks as wide-ranging as trade talks to the US government shutdown. At the same time, we are far less certain that the Fed will turn off its ‘autopilot.’ The incremental rise in financing the private sector must provide the US government as the Fed shrinks its bond portfolio is often described as a non-issue by the Fed. This rhetoric comes even as the central bank ponders comparable bond purchases as an element of policy easing in a future recession.
The tightening in financial conditions in 2018 does indeed reduce the probability that the Fed stamps out the US recovery in a burst of overconfidence. In the meantime, if the US economy successfully ‘hurdles’ investor fears, the Fed will feel vindicated and likely resume at least modest further rate increases.
Our strategy: ‘Opportunistic’ portfolios could quickly take advantage of the turn-of-the-year over-reaction in many assets. As David Bailin described on January 7 (see CIO Insights | The Case of the Missing Black Swan), investors who take advantage of equity market corrections as severe as 20% to add to positions may raise their long-term returns. This proved true in the past 60 years in all but the most extreme and unusual of circumstances. Such a reallocation seems especially appropriate for investors not allocated sufficiently to equities to begin with. At the same time, with many asset prices recovering fast in the New Year as we suspected, we need to be careful to be price sensitive on swiftly changing expectations.
Bond yields are less likely to reach highs well above last year’s peak unless growth optimism stages a remarkable rebound in the face of an aging expansion. If the Fed does continue on its tightening course, we believe the higher quality income producing assets and secular growth industries we favor will stand out. (See Outlook 2019: Safeguarding Assets).