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.
As Trade Tensions Heat Up, Market Outlook Cools Down
Earlier this year, our Global Economic and Financial Market Outlook was favorable based on expectations of a trade agreement with China, a more accommodative Federal Reserve policy, a stronger than anticipated global economy, and surprisingly upbeat corporate earnings. Since the end of April, the positive case for global and US economies has weakened resulting in a 6.0% pullback in both the S&P 500 and the MSCI All-Country World ex-US Index (ACWX). The outlook has become increasingly uncertain and a higher level of caution is warranted for stock investors.
The key negative development in May was a breakdown in trade negotiations and increased tariffs between the US and China. At this point it seems to us that the two sides are becoming further entrenched and we think an imminent resolution is unlikely. The impact of the escalating trade war will be negative for global and US growth and individual company earnings. Since there is no modern-day precedent of a major trade war between the world’s two leading economies, it is impossible to estimate the magnitude of the negative impact with any confidence. [Update: new tariffs on Mexico were announced Thursday night, which underscores this administration’s commitment to tariffs as a policy tool. This also reinforces the level of uncertainty and the fact that circumstances can change at any moment.]
We emphasize that many of the positives that drove the market higher earlier this year remain in effect. The Federal Reserve and other key central banks have turned more supportive. Business and consumer confidence remain high, with unemployment, inflation, and interest rates surprisingly low. Corporate profits have continued to surprise Wall Street analysts to the upside; 2019 full-year S&P 500 earnings and revenues are expected to rise around 5.0%. Stock buybacks are on a record pace and valuations are relatively low, further supporting equity markets. At this point, we continue to expect the US to avoid an economic and/or profits recession.
On balance, it is prudent for investors to be cautious and stay vigilant and flexible.
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.
Now What? The Road Ahead
Fears of an imminent recession sank the US stock market in the fourth quarter. The prevailing view was that the China tariff situation would deteriorate, the Federal Reserve would aggressively increase interest rates, and an economic moderation would steepen into a more serious decline. We disagreed. In our January Outlook, we forecasted that the probability of a recession was less than 10% and advised investors to be disciplined and patient. Moreover, we expected the threat of recession to recede, thereby paving the way for a market recovery. Since the start of the year, talks between US and China have progressed significantly and members of the Fed have been outspoken in assuring investors of a dovish path. By February 15, the S&P 500 Index soared over 18% from the depressed December 24 low.
At this point, the market’s valuation has recovered to its long-term norm. Looking ahead, what is the most probable market and economic scenario and what are the major threats? We think future gains are likely, but the ascent will become more difficult.
The focus is shifting away from China-US trade negotiations and Fed policy to the health of the global economy. The consensus view, which we share, is that major global economies and US corporate profit growth are slowing. Nevertheless, we consider these adjustments to be noteworthy but not alarming.
We reject the view that an economic and profits slowdown will necessarily result in a major market decline in the near-term. Rather, we think that modest gains would be consistent with historical market advances coinciding with periods of economic deceleration. During these periods, companies that exhibit sustainable earnings above market estimates have offered the best prospects.
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.
The Three Paths Ahead
Global stock markets in recent days have exhibited unusual levels of volatility in response to headline news. Daily developments impacting the future of US-China trade relations, Federal Reserve policy, the price of oil, inflation, and a possible inverted yield curve in US treasuries have rocked the markets.
We strongly recommend that the best policy for US investors coping with tumultuous conditions is to avoid reacting to these news developments and focus rather on the next 12 months. In our estimate, there are three most likely outcomes to emerge in 2019:
Scenario One (65% probability): Soft Landing
We forecast 2019 US GDP growth to be 2-2.5%, down from our 3% estimate in 2018, with corporate profit growth to rise 7-9%, down from this year’s 20% surge. Our view is consistent with the consensus of economists and investment professionals. Such a successful soft landing in combination with the improved valuation of the stock market will likely result in a S&P 500 Index advance in the 7-10% range.
There are two major threats to this modestly optimistic view. The first is a possible outbreak of a major trade war which would have a stagflation consequence and in the process leave the Fed in a “no-win” policy dilemma. We think that political leadership in both China and the US have come to the conclusion that both sides lose with higher tariffs. In the case of China, where the economy is already slowing and the government is adopting increasingly potent stimulus measures to maintain growth, a significant slowdown resulting from a trade decline could trigger social and possibly political unrest. The Trump Administration recognizes the necessity of a strong economy and healthy stock market going into the 2020 national elections and a trade war on top of an expected 2019 slowdown would probably make that impossible.
A misguided policy implemented by the Fed is also unlikely. Chair Powell and other FOMC members have recently emphasized their awareness of the necessity of basing policy on data rather than what could prove to be an incorrect forecast of economic strength and inflation. As the economy slows in 2019, we expect employment gains and inflation to moderate and cease to be a major concern for Fed policy.
Scenario Two (20% probability): Exuberant Economy
There are two equally likely, yet divergent, market responses if the US economy continues to produce GDP gains at or above 3%. In the first case, strong labor gains would lift inflation and force the Fed to raise interest rates. The stock market in this scenario would be concerned that the rise in short-term interest rates would eventually result in an inverted yield curve, a recession, and a bear market as has happened so often in the last 50 years. In the second case, expressed most recently by the Trump Administration, strong GDP growth will not be accompanied by above-target inflation and there will be no need for further monetary tightening. This might be the best of all possible worlds leading to a significant rally in global stock markets.
Scenario Three (15% probability): Recession from Policy Blunders
This highly negative scenario anticipates that the coming slowdown in the US economy and profit picture would be exacerbated by misguided aggressive tightening policies from the Fed and/or an escalation of trade wars. Here the US economy would be threatened by a recession of indefinite severity and duration and most likely foment a bear market.
We recommend investors exercise discipline and patience and base their strategies on a longer-term perspective. This includes consideration of their unique preferences regarding growth and preservation of capital. Growth investors can view the recent market correction as a long-term buying opportunity. In contrast, investors whose top priority is to preserve assets should be more cautious. In any case, the recent volatility should be used as an opportunity to review investment objectives and guidelines.
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.
Markets Drop on Surging Volatility
What just happened? Stock markets reversed sharply over the last two trading days, interrupting an unprecedented streak of steadily rising markets and low volatility. While yesterday’s result was widely noted to be the largest single-day point drop for the Dow Jones Industrial Average, in percentage terms it wasn’t anywhere near historic proportions. Nevertheless, the declines hit all the major indexes and are significant enough to warrant an urgent assessment of the markets.
Although corrections in the U.S. stock market are not unusual, the speed and intensity of the downturn the past week is concerning to many investors. Our view is that heightened volatility will continue for the near-term, but that the global economy and stock markets will eventually recover without long-term damage.
We wrote that commentary in response to the “flash crash” of August 2015 when the Dow dropped 1,100 points in the first 5 minutes of trading. Investors who held firm after that day have seen the Dow increase 53%. We believe similar advice is appropriate now. Our positive outlook for 2018 was based on the expectation of synchronized global economic acceleration, strong corporate profits, and rising but still moderate inflation. These factors remain intact despite the market’s behavior. Economic data continue to support this view, which ought to reassure equity investors.
If the economy is strengthening, why did stock values drop so suddenly? It is impossible to untangle all the causal relationships, but we can highlight three primary factors. First, last Friday, a number of investors sold equities on the fear that rising interest rates would choke off growth. Second, the Friday selloff led to an increase in price volatility, exposing a bubble in an obscure volatility-linked derivative product, which then burst. Third, computer driven trading that reacts to market momentum fed off this sudden panic and drove markets down on Monday. Thankfully, on Tuesday, they stabilized and staged a strong recovery. (The Wall Street Journal has a good explanation (subscription required) of the mechanisms of that particular derivative and how it affected markets).
What should investors do now? First and foremost, we recommend they focus on long-term investment objectives and remember that asset allocation should be designed to blunt the impact of short-term events. This past week was a reminder that the period of calm and steady market gains of the past two years is the exception, not the rule. For example, in an average year, the S&P 500 Index will trade down 2% or more five days and down between 1% and 2% an additional 20 days (Bloomberg: These Kinds of Stock-Market Losses Aren’t That Unusual). Still, even if we can expect increased volatility, accelerating economic growth should lift corporate earnings and stock values. It is true that interest rates are not as accommodative as they were three months ago. Following this correction, however, earnings multiples are much more attractive. Some caution regarding inflation and interest rates is warranted. But at this time neither has risen sufficiently to hamper economic growth or corporate profits. We will continue to closely monitor inflation as well as actions from the Fed, bond yields, and quarterly earnings. We believe the worst of the selling is behind us and that investors should stay close to their long-term equity targets.