We originally published these comments in November of last year and they still ring true. As they say, “this is our story and we’re sticking with it!”
As we leave 2018 behind, the much-hyped synchronized global expansion has plateaued, global economic growth has become more uneven, and domestic and international markets have become more volatile. While we are going to respectfully pass on short term stock market direction speculation (because as we have witnessed this past year, this can be a fool’s errand!), we are still going to risk sharing our thoughts for what lies ahead for investors and markets.
Our opinion is that growth in the US economy has a high likelihood of remaining positive and above average in the next year. We expect it to be in the 2.25% range, which will be a slowdown from 2.8% in 2018. This is a significant change in course of direction from the past couple years and will be in sync with pretty much every major region in the world.
On top of that, this year will bring the beginning of a globally uncoordinated shrinking of central bank balance sheets, which is again, contrary to the global easing cycle to which we have become accustomed. A synchronized global slowdown and lack of central bank support, combined with rich valuations in the US market, makes us more cautious about 2019 stock market performance despite the low probability of a recession. The stock market has always been a pretty good discounter of future economic activity and earnings; however, the timing of cause and effect have always been unpredictable.
Most agree, Interest rate increases this year have been justified, given the necessity to reign in the unprecedented long period of easing and balance sheet expansion by the Fed. The markets finally seem to believe the Fed is serious and are re-pricing the bond and equity markets to reflect the number of predicted rate hikes in 2018 and 2019. Most market participants agree with one more hike in December and 2-3 hikes in 2019. Assuming the Fed doesn’t tighten more than that, Treasury yields are currently fairly-priced. We would be surprised to see yields move much higher from this point. We believe the Fed will pause at 3-3.25% to test their actions and believe much higher rates are hard to justify without significantly higher growth and inflation pushing the Fed.
From a fixed income perspective, we would recommend two opposite ends of the spectrum. No harm in keeping it simple and investing in cash alternatives now that yields are at 2.5% and waiting for better opportunities to arise. On the other side, dialing up complexity and relying on security selection in flexible strategies makes a lot of sense.
Without a US infrastructure plan, the sugar rush from fiscal stimulus (tax cuts) is going to begin to wear off in 2019. We would expect equity returns to be lower but hopefully still positive in the U.S. We could see investor rotation eventually into emerging markets stocks and bonds, as the dispersion between the two asset classes and US large cap grows. It is now at its greatest divergence in 100 years. These divergent trends are historically self-correcting over 6-12 months. Most of the time, Emerging Markets rotate up in valuations, but not always. What will it be this time? Our bet is Emerging Markets move up and the US moves flat or slightly down.
In other words, we expect that the US will slow along with and/or in sympathy with other countries of the world. These nations/economies are already struggling due to our interest rate policy (hikes), then commensurate strong dollar exacerbated by their need for easy trade agreements between the Chinese and the US. Tariffs and tough talk are good medicine to a point, but eventually are damaging to world growth, trade and inevitably, stock returns.
Investors may sooner or later find solace in the face of these risks when they can finally get 3-4% yield returns in bonds vs taking equity risk. When and if this larger trend takes hold, and this is different from knee jerk short-term moves; the stock market will likely end up choppy for a year, or maybe longer. The wild cards are what the Fed will do in 2019 and beyond and the highly probable slow-down in global commerce if the trade disputes escalate between the US and China. If the Fed stops raising rates, it will initially be popular for the markets, but it also may signal longer term that they fear the US economy is slowing.
We would recommend therefore, a bit more conservative stance than normal and to keep 10-15% of your assets in a liquid, protected form, ready to use if the market really takes a panic induced dive. If all goes well, however, the US market could bump along with moderate volatility and stock returns. Emerging Markets could eventually surprise on the upside, so keep portfolios diversified. Up or down swings of 10% in global equity markets are to be expected.
In 2019, bonds may return zero, depending on Fed rate policy. In 2020 bonds could return 3.5-5% if Fed policy is normalized and the threat of interest rate hikes and therefore, principal erosion is over. Until then stay in shorter duration and higher quality bonds.
We understand this is a lot of information which can get confusing, but please rest assured, our money is invested along with yours. We are doing our best to help our clients adjust where needed and stay the course for long term prosperity.
Please contact your Deschutes advisor with any questions.