Markets rally after volatile fourth quarter

Outlook: First quarter 2019

Economy

Growth in the U.S. economy has been slowing from the high levels of last summer and is expected to revert back toward the long-term trend of 2 percent. The economy is slowing for a myriad of reasons including the fading impact of last year’s tax reform, tightening monetary policy, the trade dispute with China and weakness in some foreign countries. Given the slowing trajectory, the Federal Reserve has reduced their guidance for rate hikes this year and prices in the futures markets suggest investors are expecting either one rate increase or perhaps no further increases in 2019. Notably, growth in foreign countries is also on a weakening trend with many countries in Europe and Asia showing signs of slowing.

Inflation

Inflation rates increased steadily in the first half of last year, rising to almost 3 percent in July. Since that time, price levels have been softening with the Consumer Price Index coming in at an annual rate of 1.9 percent in December. Inflation, excluding the volatile food and energy segments, is also modest and is currently close to the Federal Reserve’s 2 percent target. Looking forward, we expect price levels to remain contained as the pace of economic growth is slowing.

U.S. dollar

The U.S. dollar increased significantly last year given expectations for a sustained series of interest rate hikes by the Federal Reserve, slowing growth in some foreign economies, rising trade tensions and the market volatility in the fourth quarter. Looking forward, we expect the dollar to remain strong, but the trade negotiations with China and the process of developing a Brexit resolution are likely to boost volatility in the currency markets while also providing directional cues based on their outcomes.

Asset class

Cash/money market instruments

After their meeting in December, the Federal Reserve raised interest rates 25 basis points to a range of 2.25 to 2.50 percent. Given last quarter’s market volatility and the expectation of softer economic data, the Federal Reserve is considering a more cautious approach to rate hikes this year. Accordingly, the futures markets are pricing in a range of outcomes for 2019 that hover between no change in interest rates and one rate increase. Despite the expectation for little or no change in short-term interest rates this year, yields on cash and money market instruments have increased significantly since the Federal Reserve started raising rates in December of 2015.

Intermediate government/credit bonds

Last quarter’s market volatility resulted in a flight to quality and a sharp decline in bond yields. For example, the 10-year Treasury peaked in early October at 3.3 percent and ended the year with a yield of 2.7 percent. In fact, the decline in rates during the fourth quarter reversed a large portion of last year’s increase. Consistent with the flight to quality in other parts of the market, spreads on investment grade and junk bonds widened sharply during December. In response, the Federal Reserve followed through with an expected rate increase in December, but members of the central bank have signaled a more circumspective approach to future rate hikes. The consistently sluggish inflation data and the softening economy afford the Federal Open Market Committee (FOMC) the luxury of pausing rate hikes, at least temporarily, to assess the data and determine the necessity and pace of future action.

While we believe that the economic cycle has not been fundamentally changed and a recession will inevitably occur, the market expectations during December were overly pessimistic. Recent data indicates the economy is slowing, but there are few signs of an impending recession. Prospectively, we believe macro factors ranging from developments in the relationship between the U.S. and China, the Brexit negotiations and guidance for corporate earnings growth will be major drivers of the fixed income and all other markets. Based on current dynamics, we prefer investment grade corporate bonds as a short duration alternative to government debt, but we are highly selective.

Tax-exempt municipal bonds

Many of the same constructive dynamics discussed last year remain apparent in 2019. These include benign credit conditions, healthy reinvestment demand, limited supply, a flatter yield curve, and a manageable impact from last year’s income tax reform. We are maintaining our strategic intermediate-term duration and given our expectations for slowing economic growth, we favor higher quality municipal bonds such as those with AA and AAA ratings.

U.S. equity

U.S. stocks declined in the fourth quarter after comments from members of the Federal Reserve that suggested interest rates may be increased significantly. These comments exacerbated fears of slowing economic growth and helped culminate the view that the U.S. is, or soon would be, on the brink of a recession. Clearly, growth rates are slowing, but there are few indicators that suggest a downturn is imminent. After a strong expansion last year, the economy is expected to return to a growth rate consistent with its long-term trend and corporate earnings are on track to follow a similar path. Last year’s earnings are estimated to have increased more than 20 percent fueled by the global economic expansion and tax reform. However, in 2019 profits are expected to increase approximately 5 to 7 percent--levels close to the long-term average. In the near-term, the markets are at a crossroads. If the Federal Reserve is able to make progress in engineering a soft landing and we get a resolution to the trade dispute with China, the markets should cheer the result. However, a policy mistake by our central bank characterized by too much tightening, or an escalation in the trade dispute are likely to result in high levels of volatility. In the fourth quarter, the market began pricing in these risks and valuations have become attractive. Currently, stocks are trading at 15x the expected 2019 earnings, a level below the long-term average.

International equity

International equities declined in tandem with the U.S. markets last quarter. Slowing growth in much of the world coupled with rising trade tensions and the Brexit negotiations have generated uncertainty about the future path of many economies. In addition, the relative economic strength of the U.S. has resulted in a strong rally in the dollar which erodes returns for U.S. investors in foreign assets. Looking forward we expect foreign markets to remain volatile. Despite the slowing rates of growth, monetary policy is on differing trajectories across the world with an easing policy employed in China while the European Central Bank is trying to unwind the crisis-based policies of the post Great Recession era. Furthermore, the negotiations between the U.S. and China regarding trade and the Europeans related to Brexit, may serve as sources of volatility. While the level of uncertainty is high, the valuations on foreign stocks are compelling, as they are trading at a substantial discount to U.S. equities.

Commodity

Commodity prices were mixed last quarter. Fears of a recession and strength in the U.S. dollar were drivers of the declines across many commodities, particularly those that are economically sensitive. For example, industrial metals declined, but gold increased in a flight to safety last quarter. Oil prices dropped dramatically as an unexpected supply glut and fears of economic weakness created a bleak outlook for the balance of supply and demand. Agricultural commodities were mixed. Looking forward, we continue to expect the slower pace of global growth to act as a headwind to higher commodity prices but acknowledge that a positive resolution to the trade dispute could result in at least a short-term rally.

Potential threats: risks and notable items to watch

Declining growth rates

Growth rates for earnings and the economy are set to decline in 2019. If the deceleration is too dramatic, asset valuations may decline as well.

Policy risks

The Federal Reserve was one of the drivers of the market downturn last quarter after providing guidance that suggested they will hike rates significantly from current levels. Recently, they have adjusted their commentary and are now suggesting they will be more patient before hiking rates again. At the same time, the European Central Bank capped its monetary stimulus program despite the region’s slowing economies. If the world’s central banks reduce stimulus too quickly, there is a heightened risk of an economic contraction.

Trade disputes and rising protectionist sentiment

Trade tensions between the U.S. and China remain high, although there has been notable improvement in the early stages of 2019. If the dispute escalates, tariffs are likely to be increased resulting in a significant headwind to the global economic expansion.

Rising interest rates and/or inflation

A shift from the current environment of low interest rates and benign inflation is likely to be problematic if it occurs too rapidly. Structural forces such as aging populations and the proliferation of technology have kept inflation at low levels, but strong labor markets may lead to an increase in wages and could force the Federal Reserve to raise rates more aggressively.

Increasing government regulation of technology companies

Several of the leading technology companies have established dominant market positions and have few competitors. If the power of these companies continues to increase, government regulators may place them under greater scrutiny by assessing their privacy policies, acquisition plans and competitive practices.

Geopolitical risks

Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. Events in Saudi Arabia are important to monitor as are developments across the Middle East and the South China Sea.

Debt-related issues

Sovereign debt levels continue to grow throughout much of the world, generating conditions associated with low rates of economic growth. In response to the low growth rates, there has been a meaningful shift in the willingness to use fiscal policy to stimulate these economies. However, if the initiatives are debt-financed, they run the risk of exacerbating the issue and creating more significant problems in the long-term.

Cybersecurity

Cybersecurity has become a significant issue as evidenced by the Equifax data breach as well as persistent attacks on both the international money transfer system, SWIFT, and on systemically important financial institutions. The global cost of cybercrime was recently estimated at $600 billion annually, up 20 percent from 2014. The rising costs are primarily caused by the significant increase in theft of intellectual property and confidential business information. Notably, 53 percent of all attacks cost more than $500,000 in financial damages, according to recent reports by McAfee and Cisco Systems.