Economic and Financial Market Outlook 2020 Q2
Remarkable developments occurred in the first quarter of 2020: the worst pandemic in over a century spread around the globe at alarming speed, policymakers responded with unprecedented monetary and fiscal stimulus, and national, state, and local governments effectively shut down the global economy in the interest of public health. Equity and credit markets responded with incredible volatility. While the selloff in the S&P 500 Index reached a low on March 23, dropping 35.4% intraday below the February 19 high, the US benchmark index also made historically fast gains, including the strongest one-week advance since March 2009. Of the 22 trading days in March, 21 saw stock market moves of at least 1.0%. When all was said and done, the S&P 500 and Dow Jones Industrial Average each incurred their worst first quarter ever. The bond market also saw unprecedented volatility, with 10-year US Treasury bond yields plummeting from 1.92% to a low of 0.50%, while high yield bonds, measured by the iShares High Yield Corporate Bond ETF (HYG), plunged over 30%. Looking ahead, our outlook is essentially unchanged from the March 20 update: “Stopping the Coronavirus: Putting the Brakes on the Economy.” We maintain that for stability to return to markets, investors need greater visibility regarding COVID-19 and its impact on the economy. At this stage, we can provide some updates to the key questions, but a lack of definitive answers continues to cloud the investment landscape:
- How much of the country will be affected by the virus, and how long before we start to see a decline in active cases and fatalities?
COVID-19 has already impacted every US state and over 180 countries with varying ferocity. Globally, new cases are still growing and the timing and severity of peak intensity in the US and abroad remains uncertain. It is somewhat encouraging, however, that a few countries have reported infection rate declines and several more have reported a deceleration in the number of daily new cases.
- How restrictive will the national, state, and local policymakers be in shutting down the economy in the interests of public health? How successful will the restrictions be in containing the virus?
The White House has recommended all Americans to stay home and 41 states have issued orders to shelter in place except for essential activities. Although these steps thankfully appear to be reducing the spread, in our view, the widespread “stay at home” orders have caused the US to enter recession of unknown duration and turmoil. In the week ending March 28, 5.8 million people applied for unemployment insurance following 2.9 million the week before (the previous highest single-week totaled 695,000 in 1982).
- When will there be a return to near-normal activity, and will the mass amounts of unemployed workers be able to resume their jobs?
We don’t know how long it will take until the number of active cases is low enough to resume normal activity, or frankly, at what that level is. What we do know is that the longer we remain in some form of lockdown, the more severe the disruption will be to economic activity and the rehiring process.
- How successful will the healthcare industry be in developing a vaccine or other remedies and how long before distribution is permitted? Will hospitals be properly equipped to treat the virus? Will the testing process be adequately advanced?
There is still a long way to go, but progress has been made in addressing shortages of necessary supplies and protective equipment. There have been promising headlines about potential therapeutic advances, but experts warn that an available vaccine will require months more of development. Based on the experience of other countries, the stay at home orders will lift long before we see a vaccine or cure.
- How quickly and how successful will the national government be in countering the economic impact of their public health measures on citizens, small businesses, and corporations?
Congress and the White House have taken a bipartisan, “whatever it takes” approach to stabilizing the economy, already passing $2 trillion in relief measures, the largest stimulus package in history. Even so, it is not clear whether the initiatives will be effective or if another rescue package will be needed to further protect against economic malaise.
- Will policymakers be able to effectively deal with liquidity problems in financial markets?
The Federal Reserve has acted stronger and quicker than in 2008, dropping the Federal Funds rate to zero and offering up to $4 trillion in asset purchases to keep financial markets functioning. The usefulness of this massive undertaking is unknown as there has never been such a crisis nor such a response. Through these actions, however, the key policymakers have demonstrated that they are 100% committed to combating a credit crunch.
- What will be the impact on corporate profits and stock buybacks, which totaled $700 billion last year? How will investors react to the threat of dividend cuts, bailouts, and bankruptcies?
The exact effect on corporate profits is yet unknown, though we know for certain that the impact will be strongly negative. Factset consensus estimates expect a decline of -4.5% in S&P 500 earnings for 2020, though this number includes outdated forecasts as many research houses have yet to update their projections to reflect current conditions. Goldman Sachs has attempted to produce relevant estimates, and now expect 2020 full-year S&P 500 profits to fall 33%. Companies especially hurt by the virus are expected to cut their dividends in the second quarter, including 21 in the S&P 500, and many more share repurchase plans have been suspended.
We normally view bonds as a stable, income-generating asset. US Treasuries remain very safe, though their yields dropped to record lows in the first quarter. Corporate and municipal bonds have not been a good income source due to low yields and now we see increased credit risk during these trying economic times. We recommend holding to maturity high-quality bonds, which should still provide portfolio stability, whereas lower-quality bonds have been severely punished during the crisis. In addition, we recommend staying short-term in duration, as reaching for yield by going further out in duration will lock in yields for years near record lows.
The situation remains in flux and new information emerges hourly. We are encouraged by some recent developments but clearly do not have the answers to know when the crisis will pass. Investors must accept that there is an abnormally large range of possible short-term outcomes and they should monitor closely developments and the changing probability of various scenarios.
We will get through this eventually. May all our readers stay healthy, safe, and in good spirits!
Does the Coronavirus Change the Outlook?
During a very eventful start to 2020, the world’s attention has been set on the serious and significant spread of the Coronavirus. A contagious, life-threatening respiratory disease, it has infected nearly 50,000 people worldwide and has killed over 1,000 people, the majority in mainland China. While our focus here is the potential economic and financial market impact of the Coronavirus, we do not want to leave unacknowledged the reality that humans are suffering. Our hearts go out to the families and loved ones who have been affected by this tragedy.
Even disease experts acknowledge that it is irresponsible to make a forecast on how long the outbreak will last, how far it will spread, and what the ultimate economic impact will be. What we do know is the Coronavirus is serious enough that a few large Chinese cities are on lockdown, some companies with factories in Wuhan are suspending operations, and several countries are enforcing travel bans to and from China. When the world’s second largest economy undergoes a disruption of this magnitude, global growth will slow. The degree to which this will impact US growth will depend on unknown future developments.
The response of financial markets has been mixed. Taking into account this problematic outlook, commodity prices have fallen. Year to date, WTI crude oil has plummeted -17.5%, copper -8.4%, and iron ore -10.8%. Likewise, the economy-sensitive S&P 500 energy and materials sectors have dropped -10.1% and -2.2% respectively, and emerging market stock markets, measured by the iShares MSCI Emerging Markets ETF, the EEM, have dropped -3.4%. On the other hand, the S&P 500 Index as a whole has continued its upward march, rising 3.2%, with technology, communication services, and utilities outperforming.
Marietta’s most recent Economic and Financial Market Outlook (January 10) was modestly optimistic based on cooling trade tensions, easy monetary policy, a strong US consumer, a return to corporate profit gains, and a global growth rebound that would reduce recession fears. Thus far, these core fundamentals remain unchanged: trade tensions continue to diminish, monetary policy remains supportive of growth, corporate earnings are still expected to rise, and US consumer spending has been relatively unimpeded by the Coronavirus. We no longer project a global growth rebound, but we continue to think that recession fears will stay low, provided a significant outbreak does not reach US shores. Thus, our outlook is relatively intact and supports the case for higher global stock markets.
We expect there will be winning and losing sectors and companies, which could provide an opportunity for active portfolio management to help mitigate portfolio risk and increase returns. The longer the pandemic takes to resolve, the greater the negative impact will be to industries such as travel, autos, oil, some luxury goods, and commodities. Companies with supply chain disruptions should be monitored closely for downward earnings revisions. We recommend caution in “buying the dip” in these industries until the magnitude of the global economic impact is better understood. Even if the virus is contained quickly, companies should be reevaluated in the context of a slower than expected global economy. We will be tracking developments closely, especially regarding a potential disruption to US consumer spending. We all wish for a swift end to this serious threat.
Economic and Financial Market Outlook 2020 Q1
We begin the new decade riding a historic economic expansion that enters its 11th year. 2019 saw global stocks post significant gains and bond markets rally for most of the year as the dominant obstacles retreated or moved closer to resolution. At this point, our economic and financial outlook for the coming year remains modestly optimistic:
- Tensions are cooling in the US/China trade war
- Global central banks have taken steps to ease monetary policy
- Global growth is poised to rebound, reducing fears of US or worldwide recession
- The indefatigable American consumer persists as a bulwark supporting the global economy
Our optimism is tempered by the likelihood that a reversal of any of these factors would lead to market declines. We also expect the coming year to bring greater volatility, although absent any fundamental deterioration of these factors, we would view any pullbacks as buying opportunities. With the potential for pitfalls, it is especially important for investors to monitor economic reports for any signs of weakening and be prepared to make quick adjustments or maintain more balanced portfolios.
In the US, the economy demonstrated its resilience with the previous quarter projected to grow 1.8%. Despite predictions from pundits that the trade war would lead to recession, the economy withstood the negative impact on the manufacturing sector from the tariffs. Indeed, the ISM Report on Business showed US manufacturing contracting in 5 consecutive months to end the year. However, service activity remained robust with PMI readings solidly expanding. The scorching labor market has shown no sign of slowdown and headlines the positive case for the US economy. The US added on average 177,000 jobs per month in 2019 and job growth accelerated into the end of the year. Unemployment is the lowest it has been in 50 years and wages are growing about 3%. The Federal Reserve restored accommodative monetary policy with three quarter-point rate cuts in 2019 and Chair Powell has signaled that it would take a significant increase in inflation or economic activity to force rate hikes. We expect the newly-dovish Fed and the strong consumer will prevent the US from slipping into recession, but we are hesitant to anticipate a new upward cycle of growth. We forecast that the US economy will maintain its 2019 pace of about 2% in 2020, with inflation hovering around 1.9% – 2.0% and unemployment holding steady.
How will U.S. stocks follow up its tremendous performance in 2019? The S&P 500 finished the year up 31.5%. However, earnings growth will probably come in negative in 2019 after the final tally. That means that the stock gains further stretched P/E multiples to the limits of what could be called fairly valued. It is difficult to imagine further advances without a pickup in corporate earnings. While the resilient economy will bring a return to earnings growth, profit estimates for this year have fallen from double digits to about 9%-10% improvement over last year’s numbers. However, higher labor costs, continued effects of remaining tariffs, and uncertainty from the upcoming election will skew the risks to this forecast to the downside. With already high multiples on stocks, our conclusion is that broad indexes will track or slightly lag earnings growth and finish the year about 6%-9% higher. In this middling environment, investors should focus on sectors and companies that benefit from secular trends that are sheltered from economic headwinds.
The global economy, which experienced a synchronized slowdown in 2019, is forecast to recover modestly this year. The International Monetary Fund (IMF) attributes the subdued growth last year primarily to increased tariff barriers and elevated uncertainties surrounding trade and geopolitics. Especially hard hit was capital spending and manufacturing. On the other hand, broad-based monetary stimulus implemented by the world’s leading central banks partially offset these negatives. Heading into 2020, the Phase 1 tariff agreement between the U.S. and China, the USMCA treaty, and greater clarity towards a Brexit solution should improve prospects for capital spending, manufacturing, and trade. Meanwhile, we expect global central bank accommodative policies to continue well into 2020. We echo the IMF global GDP projections of 3.0% in 2019 and 3.4% in 2020, which is still below the 3.8% gain in 2017. Fueled by monetary stimulus, this economic recovery will support higher global equity markets as the fears of recession that rattled financial markets earlier in 2019 diminish.
Our confidence in international stock markets is based primarily on the improved outlook for corporate earnings, subdued inflation, low bond yields, and very attractive valuations. We do not expect developed country economies (notably the Euro Area, Great Britain, Canada, and Australia) to rebound strongly: improved global conditions will likely result in modest GDP growth of only 1-2%. However, even such a mild rebound in output will support earnings growth and a corresponding stock market advance. Companies in developed country economies with strong bottom-up fundamentals will outperform, especially in consumer and technology sectors. The brightest spots in the global economic outlook are the emerging economies. The latest forecast of the IMF foresees a growth pickup from 3.9% in 2019 to 4.6% in 2020, including 5.8% in China and 7.0% in India in 2020. We are also projecting a rebound in Brazil from about 0.7% to 1.5-2.0%. This combined economic advance will come as a boost to emerging markets: over the past 5 years the iShares MSCI Emerging Market ETF (EEM) was up a meager 16.3% in comparison to the 57.4% jump in the S&P 500 Index. Additionally, a stabilization or decline in the dollar, which we consider likely, would be another positive for international markets.
The bond rally of 2019 peaked in September with the 10-year US Treasury rate nearly reaching its all-time low. Bonds yields have come up ever so slightly from their lows as global growth appears to have stabilized. We forecast a slight progression higher for interest rates that will track the pickup in growth. The synchronized efforts of global central banks to ease monetary policy will limit the potential for a significant advance in rates absent an unexpected spike in inflation. High-quality, short duration bonds continue to provide a haven for capital preservation but we caution against reaching too far with lower rated or longer dated bonds as those carry risks that would be better allocated in the equity markets.
Economic and Financial Market Outlook 2019 Q4
The economic and financial market outlook continues to be mixed. It is evident that while global GDP is still expanding, its growth rate is dropping. The US-China Trade War has exacerbated this slowdown, contributing to a global manufacturing contraction. The resulting rise in uncertainty has limited business spending and mired corporate profits, which are expected to decline for a third consecutive quarter. A turnaround could be near, however, with 2020 S&P 500 earnings projected to rise 10.5%. Another positive development is that the world’s major central banks, including the Federal Reserve, have increased monetary stimulus in response to slower growth. Historically, this has been a powerful support for stock markets. We recommend a balanced and flexible approach. Investors should be prepared for developments that alter the market climate quickly, both positively and negatively.
The US economy has enjoyed steady, albeit slowing, growth so far in 2019. Backed by a strong consumer and an outstanding labor market, economic activity has climbed despite a slowdown in trade, agriculture, and manufacturing. Goods-producing industries are in decline and the situation is deteriorating. The September Manufacturing ISM Report on Business composite PMI Index declined for the sixth consecutive month and showed that deliveries, backlogs, new orders, employment, exports, and imports all contracted. While concerning, manufacturing only makes up roughly 11% of GDP while consumption is about 70%. Thus far, the US consumer has remained one of the last strongholds of growth. If household spending can endure the current soft-patch, the global economy may rebound without further damage. If individuals tighten their wallets, however, the situation could spiral into a more serious downturn.
The impressive US stock market advance hit its peak in late July but has been range-bound since. The volatility has had a clear pattern: shaky economic data and negative trade headlines have weighed on the indices, while hopes for a Trade War ceasefire and Federal Reserve rate cuts have pushed equities higher. While much attention is currently preoccupied with these macro considerations, we think that the key to reaching new highs is corporate profits. If investors gain confidence in businesses achieving the expected double-digit earnings growth in 2020, the S&P 500 Index will likely respond with solid gains to end the year. This will not be an easy task, as profits have been slightly negative over the past two quarters and the third quarter numbers are expected to show another consecutive decline. Provided that earnings break out of their slump, the fundamental backdrop is generally supportive of higher stock markets: valuations are reasonable, inflation is low and stable, the Fed is providing monetary stimulus, and bonds and money markets do not provide competitive returns compared with equities.
The international outlook is clouded by the slowing global economy and ongoing trade tensions. China is suffering from the onslaught of US tariffs and will need significant stimulus to maintain its target GDP growth rate of above 6%. We expect the Chinese government will continue to take proactive steps to boost the economy. There is some evidence that monetary and fiscal stimulus may already be working: consumer spending and the service sector remain strong and the slowdown in manufacturing is showing early signs of a potential bottom. In comparison, the euro area is expected to confront a sharp slowdown in 2020, with Germany and Italy flirting with recession. Already, demand for goods and services is falling at the fastest pace in six years. The European Central Bank continues to do “whatever it takes” to get growth and inflation back on track, announcing in September an interest rate cut and agreement to restart its quantitative easing program. Curiously, policymakers so far have been reluctant to address aggressively the downturn with fiscal stimulus despite negative borrowing rates. The ongoing Brexit stalemate adds additional uncertainty to the region.
The positive case for international stock markets seemingly depends on a breakthrough in trade negotiations as well as a continuation of accommodative central bank policies. Global central banks will continue to ease, providing a positive backdrop for global equities. However, the near-term prospects for the US-China trade negotiations are not encouraging and the timing of an eventual agreement will be difficult to predict. We recommend exercising patience, diligently reviewing any ongoing developments. For long-term investors, international stocks present an opportunity for diversification and potential growth at substantially lower valuations than US equities. Our approach takes a bottom-up view to evaluate companies on a fundamental basis, emphasizing strong relative earnings momentum and/or recession resistant characteristics.
Bond yields fell further in the third quarter, with US 30-year and 10-year treasuries dropping to record low yields in September. Reflecting our mixed outlook, we think bond yields are likely to remain low and range-bound until a clear narrative takes shape. Money market funds have become relatively attractive and offer similar yields and additional liquidity. Higher cash-equivalent positions are currently warranted with potential future volatility on the horizon. With greater flexibility and lower interest rate exposure, investors with elevated cash positions will have the ability to return to equity and fixed-income norms while maintaining downside protection in the event of an improving outlook.
Economic and Financial Market Outlook 2019 Q3
The US and Global stock markets are enjoying a banner year. The S&P 500 Index rocketed +18.5% in the first six months of 2019 (the best first half since 1997), which included +7.1% in June (the strongest June since 1938). International equities have also enjoyed substantial gains: the MSCI All-Country World ex-US Index (ACWX) has climbed +13.4% this year. What lies ahead after such lofty returns? Despite the remarkable first half, we consider the outlook to be mixed, reflecting widely divergent views on three critical issues:
- Tariffs and trade wars
- Synchronized global central bank stimulus
- Slowing US and international economic and corporate profits
Since the Trump administration levied tariffs on Chinese goods over one year ago, sharp stock market swings have occurred regularly. When tensions rose, most indices sold off in response, such as in the fourth quarter of 2018 and May 2019 when the MSCI All-Country World Index (ACWI) retreated -12.7% and -7.3% respectively. In contrast, reports of negotiation progress and easing tensions led to meaningful relief rallies in January and June. The clock is running out on accomplishing a productive agreement; the negative effects of tariffs are already biting into profits and eroding business confidence and capital expenditures. Both sides have stated a desire to reach a deal but have found it difficult to compromise on major issues. At this point, it is difficult to predict any specific outcome with a high degree of confidence. Consequently, our recommendation to investors is to avoid strategies based upon a very positive or very negative scenario.
With respect to central banks, their policies wield powerful influence on a country’s economy, currency, and financial markets. Over the past year, many of the key banks have increasingly indicated concerns for slow growth and below-target inflation and have stated that they are prepared, if needed, to provide stimulus. This is now the case in the European Union, Japan, India, Australia, most of South America, and, significantly, the US and China. The Federal Reserve is widely expected to reduce its target interest rate in July for the first time since 2007, and many investors anticipate multiple rate cuts later this year. Historically, central bank rate cuts have provided powerful economic stimulus that has boosted flagging equity markets. If the Fed balks, global stock prices almost assuredly will respond negatively. Further complicating matters, monetary policy will be influenced by trade considerations. For example, the economic gains achieved through a US-China resolution will reduce pressure to cut rates. As we see it, future Fed action is as enigmatic as future trade conditions and prudent investors should maintain a position of flexibility and data-dependency.
Source: Council on Foreign Relations, Global Monetary Policy Tracker, June 2019 (-6.68, Easing), accessed July 10, 2019. Data Sources: Bloomberg, IMF, Council on Foreign Relations
The International Monetary Fund and other forecasters currently expect global growth to deteriorate for the remainder of this year. The world’s two largest economies, the US and China, have the greatest potential to turn around the projected weakness. The US is slowing and risks continuing down this path, with negative consequences for corporate earnings, without some stabilizing monetary and/or fiscal stimulus. However, we do not anticipate a recession and the most probable scenario includes a pickup in corporate profits by year-end. China’s GDP has been decelerating for 15 years from the double-digit rates of the mid-2000’s to 6.5% in 2018, and the government is determined to hold the line at 6.0%. Government officials have already adopted numerous policies to reverse a slumping economy, which was apparent even before tariffs were enacted, with uncertain result. Since these two countries account for about 40% of global GDP growth, their success will determine whether the world’s economic situation will flourish or languish.
The US stock market will continue to benefit from a variety of supports. Stock buybacks and merger and acquisition activity show few signs of letting up. The bond market does not offer attractive returns to draw investors out of equities. Many common stocks provide dividend yields in excess of bonds and money market funds and some investors, especially retirees, depend on stocks to provide essential growth of principal to fund withdrawals. This is not to denigrate bonds, which remain useful to investors desiring to dampen portfolio volatility and reduce their allocation to equities.
In summary, we see many positive economic factors that run concurrent with rising risks and negative data. Moreover, key determinants cannot be easily predicted at this time. In a market expected to remain highly volatile with the distinct possibility, if not probability, of a correction sometime this year, we suggest that investors give careful consideration to their equity ratios.
Economic and Financial Market Outlook 2019 Q2
Despite the current deceleration in global and US economic growth, we think the outlook for the world’s key stock markets is modestly positive.
- We anticipate a second-half acceleration for most advanced and emerging economies and, despite recent soft data, we reiterate our forecast for 3.4% global GDP growth in 2019.
- US stock markets will benefit from economic stabilization, a supportive Federal Reserve, and low inflation and interest rates.
- The Chinese economy and stock market will improve in response to stimulus measures and could further gain from a US tariff resolution. Europe’s challenges will persist.
- Risks remain apparent but should be weighed against a solid environment for potential stock market gains.
- We categorize our outlook as “modestly positive”: the balance of encouraging factors and visible risks tilts moderately in favor of sustained equity investment. Excessively positive or negative fundamental scenarios are based on unlikely developments.
The US economy has decelerated from last year’s robust growth. GDP growth peaked at 4.2% in the second quarter of 2018 and sequentially dropped to 3.4% and 2.2% in the third and fourth quarters. Current estimates for the first quarter indicate a third consecutive slowdown. A major fear of some investors is that this trend will continue until the US economy enters recession. We reject this view and confirm our position that a growth rebound will occur, potentially as soon as this quarter. Though we are unlikely to see GDP growth greater than last year’s 3.0%, we project that steady growth this year of 2.0%-2.5% will be enough to maintain a strong labor market, healthy consumer spending, and improved manufacturing demand. Indeed, the April 4 weekly jobless claims hit a 49-year low.
The US stock market has recovered as focus has shifted beyond recent weakness, with the S&P 500 Index soaring 13.7% in the first quarter. Despite this considerable surge, investor sentiment is still largely negative, which we consider encouraging. A recent Merrill Lynch Flow Show report tallied nearly $80 billion of outflows from global equities in the first quarter. This indicates that the improving situation is not fully reflected in stock prices. The persistent pessimism could be due to the widely expected earnings decline in the first and possibly second quarters. We anticipate this will be transitory, brought about by unique circumstances including the longest government shutdown in history, a hangover from the fourth quarter market correction, and unusually bad weather. A second half economic acceleration should boost full-year S&P 500 profits, but we are reducing our prior forecast of 7.0-9.0% to around 5.0%. Historically when earnings are muted, the stocks of companies exhibiting above-average growth have outperformed.
Though the economic and profit backdrop has been more challenging, other fundamental positives remain. The Federal Reserve has indicated that they will not raise interest rates again this year. We expect the Fed to be data dependent, including the possibility of lowering interest rates should the economy demand monetary stimulus. Inflation is low and stable and has little prospect of surging upward. Valuations are reasonable and stock buybacks have totaled more than $270 billion already this year, signaling optimism for the rest of 2019.
International stock markets have rebounded from an oversold condition in 2018, though many economic indicators have deteriorated. This upsurge has been fueled by better-than-feared data out of Europe, improved growth prospects in southeast Asia, and optimism for a US-China trade resolution. Already Chinese policy makers have introduced stimulus measures which are making a positive impact, laying the groundwork for a second-half pickup. We are encouraged by recent Purchasing Manager’s Index (PMI) data (see chart) that showed expansion in manufacturing, which motivated J.P. Morgan economists to revise upwards their full-year China GDP estimates to 6.4% from 6.2%. Though this turnaround will also help the situation in Europe, the investment case is weaker there due to uncertainty regarding Brexit, Italy, and the ECB. Growth in the emerging economies is expected to exceed developed economies, with India and Brazil the most attractive for investors.
Bond yields fell further in the first quarter, reflecting weakening economic growth. At this point, we think that yields are unlikely to fall much more, considering our outlook for a second-half pickup. Our view is that now is not the time to lock in current rates on long maturities. Medium to short term bonds can provide flexibility and portfolio stability. On a related note, we would be remiss if we did not include a comment on the yield curve. A yield curve inversion, meaning that it costs more to borrow in the short-term than it does in the longer-term, is considered by many investors to be a recession indicator. This occurred in the first quarter, with the yield on 3-month T-Bills surpassing the 10-year Treasury rate. This may sound concerning, and while it has strong predictive power for coming recessions, its occurrence normally precedes recession by 12-18 months. What’s more, this interim period usually coincides with rising stock markets. This is, however, more evidence that we are in a slowing period and investors should remain attentive to new developments.
Economic And Financial Market Outlook 2019 Q1
Despite heightened year-end volatility, we confirm our cautiously optimistic outlook summarized in our December 7 blog:
- The US economy will slow from its approximate 3.0% growth in 2018 to 2.0%-2.5% this year and corporate profit growth will decelerate from its 20% plus pace to about 7%-9% in 2019.
- The major threats to this “soft-landing” remain an international trade war and a policy mistake by the Federal Reserve. We place a relatively low 10% probability on the US falling into recession.
- We think the S&P 500 Index was oversold at year-end and will recover from its -4.4% performance in 2018 to return at least 9.0% this year.
- International economies will also moderate, though global GDP growth is expected to slow from about 3.7% to a still satisfactory 3.4% this year.
- International equity markets provide even more attractive valuations than the discounted US market. Significant opportunities exist for long-term investors in emerging markets if, as we expect, China maintains healthy growth and a global recession is avoided.
The US economy, unlike the stock market, enters the year with considerable strength. The unemployment rate is at a 49-year low, consumer confidence is near 20-year highs, wage growth is rising at the fastest pace since 2009, manufacturing and confidence surveys are robust, and inflation is anchored near 2%. Some of the recent boost can be attributed to one-time benefits from tax reform, so we expect 2019 growth to ease toward longer-term trends. However, it would take a meaningful shock to overthrow this considerable momentum and create a recession. Such disruptions potentially could arise from all-out trade wars or major policy errors from the Fed. We are encouraged by recent developments on both fronts, but we are not yet out of the woods. The Fed has indicated that it will make decisions based on incoming economic data and has decreased its projected 2019 rate hikes from four to a maximum of two. As for the US and China’s trade confrontation, significant progress has already been made; additional tariffs have been put on hold and negotiations have resumed. Pressure has increased on both sides to resolve the conflict as the trade war has begun to negatively impact economic growth. We think each side understands that both countries will lose if an escalation occurs.
In stark contrast to the booming US economy, the US stock market had its worst year since 2008 and suffered three falls of 10% or more throughout the year, two of which were in the fourth quarter alone. The stock market weakness occurred despite corporate profits rising over 20% in 2018. The impact of this earnings divergence on today’s market is that the S&P 500 Index price earnings ratio (P/E) of 14.1x is below both the five and ten-year average of 16.4x and 14.6x. With a cheaper than average market valuation and expectations for solid 7-9% corporate profit growth this year, stocks look attractive. A significant advance, however, will require investor sentiment to shift.
It is also useful to place the current market downturn in perspective. From its peak last September 20, the S&P 500 Index fell just under 20%, the traditional definition of a bear market, by Dec. 24. Since 1980, there have been 12 occurrences when the S&P 500 Index declined between 10% and 20% and on average it has taken less than four months to recover the previous highs. If the market were to drop further and enter a bear market, long-term investors should take note that from 1900-2018 there have been 32 bear markets, or about one every 3.5 years, and they have lasted an average of 367 days. Additionally, multi-year bull markets typically follow bear markets, with the strongest gains in the first year of recovery. In the year following the last three 20% declines, the S&P 500 Index gained an average of 32.5%.
We expect global GDP to slow in 2019 from 3.7% to 3.4%. A significant portion of this decline may be attributed to a deceleration in the US, which accounted for approximately 24% of global GDP in 2017, and to China, which accounted for 15% (source: IMF). Their combined importance to global economic stability is manifest, and our growth estimate assumes that both the US and China avoid recession in 2019. We also expect growth to slow but avoid recession in the leading advanced economies, including the euro area and Japan. These slowdowns will be offset by a pickup in several key emerging economies.
There is currently as much controversy regarding the future strength of the Chinese economy as there is the US economy. We predict a modest GDP growth decline from 6.5%-7.0% to 6.0%-6.5%. Our view is that the ability and the determination of the Chinese government to maintain at least this level of growth is underestimated by many economists who consider a plunge to be inevitable. To respond to their slowing economy Chinese policy makers are reducing taxes, easing banking restrictions, accelerating infrastructure spending, and lowering the reserve requirement ratio. We also think that they will respond to acute pressures and reach a favorable agreement with the US on trade policy and intellectual property concerns. If a trade peace occurs in congruence with the monetary and fiscal stimulus measures, investment in many of the stocks of Chinese companies and companies that do business in China, which have been severely damaged, could be rewarding.
A case can be made for emerging market stocks based on valuation and sentiment. 2018 marked another year of disappointing market returns for emerging market companies, and over the past five years, as measured by the iShares MSCI Emerging Market ETF (EEM), they have returned a paltry 7.7% versus a gain of over 50% in the S&P 500 Index. Their 11.7x P/E has declined to a level that is extremely attractive compared to other global markets. Emerging market corporate profits are expected to be high-single digits in 2019 amidst steady economic growth in major economies. We think many patient long-term investors will conclude that the multi-year trend of emerging market underperformance has ended, and investments in these companies may prove to be very timely. Worth noting here is that the EEM fell only about half the S&P 500 Index in the 4thquarter 2018, even though emerging market stocks are often considered to be higher risk. A trend reversal may already be underway. Stability in China is paramount to the case for emerging market stocks, as China consumes about 50% of global commodities. Another key consideration are the pro-growth policies of governments and central banks, and we think Brazil and India offer prime candidates for investors.
We agree with the IMF that none of the major advanced countries in Europe and Asia present significant growth prospects. Further, the euro area lacks cohesive leadership and there will be ongoing “Brexit” headaches, Italian debt issues, and the threat of political instability in France and Germany. We think this will depress economic output and investor sentiment. Without additional stimulus measures, the equity markets of non-US developed countries are unexciting but individual company fundamentals should still be considered. Our bottom up approach in this area tends to focus on consumer discretion, health care, and technology companies.
Medium and long-term bond yields fell from recent highs in the fourth quarter as investors sought safety amid a volatile stock market. We expect bond yields to remain range-bound in 2019, with 10-year Treasury yields fluctuating between 2.5%-3.0%. Bonds that are investment-grade, high-quality, and relatively short in duration should continue to provide portfolios with capital preservation and a modest income stream. However, not all bonds are created equal. We do not recommend increasing risk to get higher yields by investing in low-quality junk or longer duration bonds. Investors wanting to take on more risk should do so in the stock market.
Economic And Financial Market Outlook 2018 Q4
- The three- to six-month outlook for stock markets is generally favorable.
- Forecasting beyond six months is more challenging than in the past due to greater uncertainty regarding growth, trade, inflation, and fiscal and monetary policy.
- Given the cloudier medium-term view, investors should review asset allocations and confirm their portfolio strategy.
The decade-long global expansion has continued into this year’s second half, led by a robust US economy. While aggregate growth has increased, it has been more uneven than the broad-based acceleration last year. Several key economies slowed from their 2017 pace, notably the Eurozone, Japan, and the UK. Looking ahead, we agree with the IMF’s projection for global GDP to rise 3.9% in 2018 and another 3.9% in 2019. The challenging stock market conditions of the first half of the year began to abate in the third quarter as many of the major fears of investors subsided: inflation did not spike, global growth did not weaken, and the US dollar paused from its rapid rise. The US stock market responded especially positively, backed by corporate profits in excess of 20% through the year’s first six months, over $1 trillion in scheduled buybacks and dividends, and still limited competition from bonds and money market funds. However, the global trade situation deteriorated more than expected, which continued to put pressure on international equities and elevate uncertainty. In the short-term, we think that global stock markets should trend higher, reflecting healthy fundamental financial conditions. On the other hand, the road ahead will include increased volatility as risks of policy errors rise.
The US economy has been outstanding, with quarterly real GDP growth of over 4% for the first time since 2014. Employment data continues to be very strong, small business and consumer confidence readings are at or near multi-year highs, and manufacturing surveys show a sustained expansion. Consumers, invigorated by lower tax rates and favorable employment prospects, are spending at a rapid clip with retail sales +5.2% so far this year. Despite this auspicious backdrop, an increasing number of CEO’s and managers are cautious about next year, citing trade tensions and labor shortages. Tariffs have the same effect as increasing taxes on US companies and this extra cost pressures profits. Finally, we are watching closely the housing market, which has seen a year-over-year decline in existing-home sales and new home construction, and a pickup in foreclosures. We do not consider this to be a red flag at current levels as this hiccup is far from the extreme depths of past crises, but a continued slowdown will be a drag on the otherwise stalwart economy. We reiterate our expectation for the US economy to continue its above-trend growth in 2018 with a more moderate increase in 2019.
The major US indices fully recovered from the market correction in early 2018 and set new all-time highs in the third quarter. We think the US market remains promising in the short-term, bolstered by a strong economy, rising corporate profits, and record stock buybacks and dividends. S&P 500 company earnings soared over 20% in the first two quarters of 2018, and analysts project a 19.3% and 17.2% rise in the third and fourth quarters respectively. Initial estimates for 2019 are also propitious, with a further 10.3% rise expected. Though stock market indices have risen, equities have not kept pace with the surge in company earnings. This development results in lower, more attractive, valuations than this time last year. With record levels of stock buybacks providing a steady stream of buying activity and the relative unattractiveness of bonds and money markets, near-term fundamentals are compelling. However, the recent recovery in the market hasn’t been as strong as it appears on the surface. Small cap stocks fell -3.2% in September, and a majority of the positive S&P 500 gain so far this year has been concentrated in just a select few mega-cap companies. A healthy market includes broad-based participation. We will be monitoring this developing scenario carefully. A further narrowing in the stock market would warrant more caution.
A refrain echoed by many investors and the financial media is that the bull market has gone on so long that it must end soon. We reject the notion that a bull market can end simply from old age. Instead, there needs to be a catalyst that brings on a sustained and substantially negative stock market. Often, that trigger is a recession. There are two prevailing narratives that the Marietta investment team considers most likely to cause the next bear market. First is that the US economy will heat up too much too fast. If US real GDP continues to rise 4% per quarter, the growth probably will be accompanied by higher wages and inflation. In response, the Federal Reserve may ratchet up interest rates faster than the market expects and slow down the economy, ultimately causing a recession. The second scenario is that the boost from tax cuts will be ephemeral, growth will slow to a crawl, the huge budget deficit will cause borrowing costs to rise, and the next recession will be ushered in with fiscal austerity and trade wars. To be sure, we do not think that either of these scenarios will come to fruition in the next 3-6 months. However, we are scrutinizing data daily to see how the economic and financial picture changes.
In contrast to US equities, most international stock markets did not rebound in the third quarter with the MSCI All-country World Index (ACWX) providing a paltry 0.9% total return, still down 9.9% from the January highs and -3.1% year-to-date. Advanced economies have produced a lower GDP output than expected in 2018 but are still showing improved incremental growth. Emerging economies have enjoyed stronger growth from oil exporters as the price of oil has risen but complications with the strong dollar have caused some financial stress in countries with high debt levels. Tax relief has not benefited overseas corporations, so their steady 5%-8% projected profit growth pales in comparison to their US counterparts. The use of tariffs as a tool to gain trade concessions has also soured investor sentiment toward international investing, exacerbated by the escalating tensions between the US and China.
The underlying economic situation in international economies is not, in fact, bad. Inflation is low and stable in key countries and purchasing manager index data supports further expansion. International equities offer a significant discount to stocks in the US, and in many cases, even more so now than at the beginning of the year. The fundamental backdrop for international stock markets would be attractive in isolation. However, they have been buffeted by macroeconomic obstacles while the US stock market has been insulated from the negative sentiment thus far. This prevents us from having a more optimistic outlook for international equities. Currency stabilization and proactive budgetary reforms in certain countries would be a good step forward, but for the lid to lift off international equities we think that a resolution to the trade war with China is required. If this occurs, we think investors will witness a swift and significant rise in international stock markets.
Bond yields have moved steadily higher, with benchmark 10-year US treasuries reaching levels not seen since 2011. The upward swing in yields corresponds with the Federal Reserve raising short-term interest rates an additional 25 basis points each quarter thus far in 2018. The result has been that longer-term bonds have provided negative year-to-date returns, while those with shorter duration have outperformed. For example, the Bloomberg Barclays US Aggregate 1-5-year bond index was nearly flat with a -0.1% return, while the Bloomberg Barclays US Aggregate Credit 5-10-year index declined -2.0%. We expect this trend to endure in the short-term and continue to recommend buying high quality and maturities of five years or less. We think that patient investors will be able to purchase bonds with higher yields at year-end.
Economic And Financial Market Outlook 2018 Q3
The case for a continuation of the 2017 synchronized global economic acceleration, which proved so beneficial to the worlds stock markets last year, has faded modestly. Whereas global GDP growth jumped from 3.2% in 2016 to a healthy 3.8% in 2017, we now expect a modest increase to 3.9% in 2018. As in 2017, all the world’s largest economies are expected to contribute to this growth. The brightest spot in this forecast is the surging US economy, which will likely enjoy its strongest year since 2005 and produce corporate profits in excess of 20%. Normally such strong fundamentals here and abroad would result in improved equity markets. Since late January, however, the elevated risk of trade wars has overshadowed macroeconomic positives and resulted in disappointing returns:
We anticipate volatility will remain elevated and at times unnerving, but by the end of the year favorable stock market conditions, including strong earnings, record buybacks, improved valuation, and lack of competition from bonds and money market funds, will drive stock values higher.
The US economy gained momentum in the second quarter and remains on track for a second consecutive year of accelerating growth. Retail sales are robust, up 5.2% thus far in 2018 and surging 5.9% in May. The labor market is hot, with headline unemployment below 4%. Manufacturing readings indicate high levels of activity. While current data have been substantially positive, this was widely expected following stimulative tax cuts and strong global demand. Now the key question is: will higher growth rates persist beyond 2018? In June, the World Bank predicted that US GDP growth will slow from 2.9% in 2018 to 2.5% in 2019, and return to the 2.0% level in 2020 (Global Economic Prospects: The Turning of the Tide? 2018. Washington, DC. World Bank Group). While our forecast is slightly higher than the World Bank, we think a slowdown in future years is likely as the sugar rush of fiscal stimulus wears off and protectionist trade policies slow economic activity. Already we are hearing cautious comments from management in a multitude of industries that include slowing new orders and rising costs due to tariffs. Though the expansion may be peaking, we forecast a measured multiyear deceleration to GDP growth more in-line with the average 2.1% from 2011-2017.
Investors need not worry though, as a decelerating economy has accompanied a rising US stock market in the past. Since the 2001 recession, growth slowed in 6 of the 16 subsequent years absent a recession. In each of those years, the S&P 500 total return was positive with an average return of 12.1% and a median return of 8.8%. We think that US equity markets will continue to trend higher if, as we forecast, corporate profits continue to rise, inflation stays relatively low and stable, and the Federal Reserve does not dampen growth by raising interest rates too quickly. Following 20% plus profit gains in 2018, we project a solid 10% increase in 2019. The outlook for inflation is more complicated. Longer-term deflationary pressures persist, including aging demographics, low productivity, and increased pricing competition. On the other hand, steel and aluminum tariffs are already pressuring prices higher with additional tariffs in the pipeline. A further concern is the tight labor market producing higher wage costs. Though recent developments have pushed inflation through 2.0%, we think it will gradually rise to around 2.5% but not spike to an alarming level. This will allow the Fed to continue its measured pace of interest rate hikes with an eye toward normalizing rates rather than slowing down an economy that is running too hot.
On the international front, macroeconomic conditions remain supportive of a further advance in most equity markets, although growth is moderating from very favorable conditions in 2017 and risks are mounting. Last year, both advanced and emerging economies benefited from:
- Persistently low inflation resulting in continued monetary policy accommodation
- Strong growth in Asia, led by China and India
- Surging corporate profits above 20%
- Improved commodity prices, benefiting many export-oriented countries
- A weaker US dollar, especially supportive for emerging markets
- A notable rebound in global trade
Momentum carried into 2018, but fears of trade wars and the negative impact of a strong dollar upset investors and brought about stock market declines. The recent pullback is not reflective of positive economic fundamentals. The euro area is slowing but to a sustainable rate. Purchasing manager index data are still expanding, a weaker Euro should fuel exports, and core inflation remains below the ECB target, which has resulted in more accommodative monetary policy than expected. While we forecast the US and EU to slow modestly in 2019, the driver of the global expansion will continue to be emerging markets, which in aggregate account for almost 60% of world GDP and over 70% of global growth. Our outlook remains that international company profits, led by those domiciled in emerging countries, will grow double digits this year and next and lift stock prices.
In our view, a further escalation of trade wars and a continued rise in the dollar are the major threats to global prosperity and rising stock markets. We think the imposition of tariffs are an economically and geopolitically destructive strategy to gain trade concessions. Additional restrictive policies would likely end the rebound in global trade and reduce global GDP growth. Fearing this, investors have fled to the safe-haven US dollar and called into question the debt levels of certain countries, including China. If trade hostilities recede, we would anticipate a huge and swift positive impact on international markets, which currently have very attractive valuations.
The US bond market has undergone a significant shift this year. Bond yields have risen substantially since the end of 2017, driven up by interest rate hikes from the Fed and stronger economic growth. The result is that most bond funds have a negative year-to-date return and bond values have fallen. However, investors who hold bonds to maturity will still receive net gains in combined income and principal. Of note, short-term bond yields have risen faster than long-term yields. In the past an “inverted yield curve” has been an indicator of recessions; this occurs when the yield on two-year treasuries rise above ten-year treasuries. We do not forecast an inverted yield curve this year but we will closely monitor the developing situation. We continue to recommend holding high quality, short- to medium-term bonds to maturity to limit downside risks to rising rates.
Economic And Financial Market Outlook 2018 Q2
Throughout 2017 and entering 2018, global equity markets moved steadily higher with historically low volatility. Supporting the optimism were the favorable conditions of improving economic growth and soaring corporate profits in combination with low inflation, low interest rates, and accommodative central bank policies. In early February, new threats to this auspicious backdrop emerged. By February 8, the S&P 500 Index plunged 10% from its late-January highs, the first decline of this magnitude since February 2016, and volatility persisted for the rest of the quarter. Two fears dampened investor enthusiasm. First was that in the U.S., a tight labor market and increased economic demand would trigger wage inflation, which in turn would lead to rising bond yields, below-expectation corporate profits, and above-expectation interest rate increases by the Federal Reserve. Second was that newly proposed tariffs would escalate into stagflation-inducing trade wars and possible recession. In our last Outlook, we identified an inflation spike and trade wars as potential, but improbable, hazards. Clearly the risks of both have become elevated and some caution is warranted. At this point, we think these anxieties will dissipate. We continue to expect the global economy and corporate earnings to remain robust, equities to recover, and bond yields to rise steadily as the year progresses.
The U.S. economy is on its strongest footing in a decade. We agree with the consensus view that 2018 will mark a second consecutive year of accelerating GDP growth and we reiterate our forecast for a healthy 3% increase. First quarter data showed broad-based positive readings pertaining to the labor market, consumer confidence, and business confidence and investment. Housing is still a positive, though increased supply would help to put more families into homes. Corporate profits are poised to benefit enormously from increased economic activity and lower taxes. FactSet indicates that analyst’s first quarter earnings estimates have increased dramatically for companies in the S&P 500 and that full year expectations have increased too, from 11.4% to 18.5%. The upward revisions to estimates were record-highs, with a record-high number of companies issuing positive guidance in the last reporting quarter. To be sure, these projections do not factor in an aggressively hawkish Fed or fallout from trade wars.
In early February, the market responded very negatively to a strong employment report that included a surprising rise in wage growth, a leading indicator of inflation. We think price indicators should be tracked closely, but at this point do not see convincing evidence that there will be an imminent inflation upsurge sufficient to disrupt consumption behavior or bank lending. The latest reading of the core PCE index, often thought of as the preferred measure, was a below-target 1.6% change from a year ago. We agree with the consensus projection that inflation will modestly rise to near 2% this year, which should not provoke the Fed to increase the magnitude or speed of future rate hikes. The benchmark interest rate has been raised five times in the past 15 months without upsetting investors or damaging the economy. We expect the Fed to continue its measured and non-threatening approach.
Investors are understandably terrified of the prospects of a trade war, especially one that includes policies targeting China. We consider it unlikely that the executive branch would participate in a trade war, which would almost certainly induce stagflation, depress the stock market, and damage its party’s November election prospects. Rather, it seems to us that President Trump’s negotiating tactic is to come out strong at first but subsequently accept a more modest agreement. The new South Korea trade deal shows that the administration is more interested in getting positive outcomes than vindictively punishing partners. We think this will also be the case with NAFTA and China. Moreover, Chinese cooperation is paramount in working out a solution with North Korea. Nevertheless, negotiating protectionist tariffs can easily get out of hand, especially in countries where nationalism influences government policies. We will continue to monitor the situation carefully.
We highlighted the year-end accelerating strength of the global economy in our January 8 Outlook, and projected the world’s GDP growth to rise from 3.7% in 2017 to 4.0% in 2018. The International Monetary Fund on January 11 issued a similar optimistic forecast:
The cyclical upswing underway since mid-2016 has continued to strengthen. Some 120 countries, accounting for three quarters of the world GDP, have seen a pickup in growth in year-on-year terms in 2017, the broadest synchronized global growth upsurge since 2010…Purchasing managers’ indices indicate firm manufacturing ahead, consistent with strong consumer confidence pointing to healthy final demand.
Our forecast for advanced economies, which include Europe, UK, Canada, Japan, and Australia, has been revised upward to above 2% in both 2018 and 2019. The major contribution to global growth, however, will come from emerging economies with increases of about 5% in each of the next two years. Leading the way will be developing Asia, which is expected to expand at a 6.5% clip and account for over half of world growth. The economic recovery in Latin America is also expected to strengthen, especially in Mexico and Brazil, to above 2% in 2018 and 2019. Emphasizing the synchronized extent of the expansion, the IMF also anticipates a pick-up in emerging Europe, the Middle East, and Africa.
International financial markets have been and will likely continue to be very sensitive to headline inflation and tariff developments in the U.S. If our forecast that U.S. inflation and trade-war fears will gradually decline without disrupting growth and profits is correct, then very positive fundamental international economic conditions will likely trigger international as well as U.S. stock market rallies. As was the case in 2017 and early 2018, investors are expected to go where growth is greatest. The major beneficiaries will likely be growth-oriented companies in emerging countries. Also attractive will be multinational corporations with heavy sales into emerging economies. One possible risk to this favorable forecast is a significant slowdown in China. Another concern is the possibility that central banks will change their accommodative policies. As noted above, we think the greatest threat to international equities is a global trade war which will prove especially damaging to export-oriented emerging economies and companies.
Bond yields are likely to rise slowly, reflecting stronger global GDP growth and a slow winding down of central banks’ balance sheets. Yields are unlikely to spike higher, however, due to low interest rates abroad and low inflation. Investors should consider short to medium term, high quality bonds in order to decrease portfolio volatility.