When Donald Trump was elected in November 2016, markets soon applauded him as a tax-cutting, regulation-slashing, business-focused President. The welcome mat was withdrawn during 2018, however, as trade wars started to unnerve investors and stall business spending.
The trade spat was seen as symptomatic of an unpredictable Trump presidency and this uncertainty rattled markets. The shutdown of the US government over Christmas seemed to reaffirm market fears that there may be something ideological, not purely business-friendly, about the US administration.
The other major concern in 2018 was interest rates; how far the Federal Reserve Board (Fed) would raise short-term rates and how high long-term bond yields would climb. Although in December Fed Chair Jerome Powell announced a softening of rate hikes for 2019 and beyond, markets wanted more reassurance – and perhaps underestimated the impact of unwinding Quantitative Easing (when the Fed is selling assets rather than buying them).
Together these issues delivered a poor equity return in 2018. And despite being the most resilient during the year, the US market finally succumbed and had the worst Q4 return since the 2008 global financial crisis (as opposed to the usual Santa rally). It was the worst December since 1931 (in the depths of the Depression). Oddly, neither government bonds nor gold provided a positive return, making 2018 a year where nothing really protected capital.
Should investment markets have reacted so badly in 2018?
Algorithmic programmes, high-frequency trading and other forms of computer-driven investment were pinpointed as causes for the relentless asset falls and there was definitely a technical aspect to the glum mood. However, there was also something else happening in the valuation of shares.
Since the value of a company’s share is linked to the company’s estimated future earnings growth, anything that may weaken potential future earnings – be that rising interest rates or trade wars – can lead to lower share valuations.
The extent of this lower valuation though has been massively exaggerated by market fears. This can be seen by the fact that corporate profits have continued to rise; for corporate profits to rise 25% and markets to fall 6% means a sharp derating has taken place, rather than a more rational recalculation. And that’s just for the US; other markets fell 10% to 25%, against positive earnings growth. We therefore believe that the doom and gloom has been overdone considering the fundamentals.
So, what now for investment markets in 2019?
Economic growth and corporate earnings
It’s true that US economic growth is poised to moderate in 2019, but the slowdown is likely to be mild, from 3% in Q2 and Q3 2018 to perhaps low-to-mid 2s in 2019. At the same time, those economies that softened in 2018, like Europe, China and Japan, may recover somewhat as their policy makers provide fiscal and monetary stimulus. China’s activities are always difficult to gauge, but housing support, tax cuts and interest rate reductions are on the cards. Likewise, the depressed eurozone may provide some cheer, with budget deficits widening in France and Italy. Even the UK could espouse expansionary policies, as austerity is phased out against an uncertain Brexit backdrop.
US corporate earnings may have a high hurdle to beat in 2019 given the tax cut impact on 2018 income, but the estimated profit growth is still positive, a far cry from the sharp drops normally seen during a recession. It simply means the growth curve is less steep, not that it is going into reverse.
The relationship between the US and China is fraught with many more conflicts than just trade, with questions about intellectual property transfers, market access and cyber activity. The recent warm statement by President Trump, echoed by the Chinese authorities, has not quite dispelled the worries about trade tariffs in the context of these other issues. We wonder, though, whether the Trump administration’s unpredictability in foreign policy will remain as the 2020 election deadline draws closer. Which course of action is more likely to get President Trump re-elected: signing a trade deal with China or raising tariffs to ever higher levels? To us, the answer is clearly the former and yet markets are incorporating a large US-China risk premium. We don’t believe the US is willing to scupper its own economy to bring China down. At some point, ‘realpolitik’ must kick in and we see it happening early in 2019, but until things are signed, sealed and delivered, markets will stick to their disbelief.
The Fed wants to be ahead of potentially higher inflation by raising interest rates to a ‘normalised’ level from the 0% emergency rate after the 2008 crisis. But inflation is remarkably well behaved in the US and literally all over the world, so there is no need to cause a slump to stop prices soaring. The Fed will, of course, keep the option open to continue hiking but is unlikely to generate a recession in doing so. Even a 3% Fed funds rate (short-term US policy rate) is unlikely to trigger a slump, but markets are more worried about it than economists.
A looming recession?
Not everything will be resolved in 2019 but even if some of the issues currently dogging the markets are less virulent in the year ahead, we should see a favourable environment for risk assets.
There are many relevant historical comparisons; in 2011 and 2015 for example, nasty market falls were prompted by fears about various economies. However, these were eventually softened by policy action (government or central bank) with risk markets enjoying two good years afterwards.
The ubiquitous concern about a 2020 recession and the upcoming end of this cycle highlights the lack of understanding about what this cycle has been: one of the longest, yes, but also one of the weakest, hence not yet earmarked for the rubbish heap. If there is any silver lining to 2018’s market turmoil, it is that its mere existence may have helped to prolong this economic cycle by delaying the time when central banks bring on a recession.
How should investors navigate 2019 markets?
We would prefer equities to bonds and cash. Within equities, our preference goes to the US, Japan and emerging markets over Europe and the UK. We need to be flexible though as we may change our opinion during the coming year, particularly if some Brexit outcome makes the UK market more exciting (it looks increasingly likely that Brexit issues will extend beyond the expected March deadline).
If this economic cycle is not dead yet, then emerging markets, which have suffered the most, should recover. The US still attracts us based on growth in some sectors like technology and healthcare. Japan is a stock-picker’s paradise where the index does not fully reflect the creativity of the new wave of ‘Japan Inc.’ but also where bloated corporate cash balances are finally being put to profitable use.
We are still sceptical that commodities will deliver a real return given the oversupply in some metals and energy sectors, but we would not be surprised to see a short-term rally in oversold commodities, like Brent and West Texas Intermediate (WTI) oil.
We have not quite crossed the threshold where government bond yields should make up a significant part of your asset allocation. If 2.65% for a US 10-year treasury bond does not stir us, then 1.2% for a 10-year UK gilt most certainly doesn’t either, not to mention 0.2% for a 10-year German bund or 0% for a Japanese government bond. Corporate bonds should benefit from improved risk appetite and we would still select them over government bonds.
Dollar vs. sterling
Currencies created some volatility in 2018 with a US dollar rally contributing to the overall risk-off mood, but in 2019 we may see less buoyancy for the dollar as the US economy outperforms other countries by a smaller margin. Conversely, the pound may be the coin to watch. Any resolution of Brexit, other than no deal, is likely to boost sterling. It may also lead to a rise in Bank of England rates and in long-term gilt yields.
Choose active stock-picking for 2019
Ultimately, what will make a difference in 2019 – in addition to getting the overall direction of markets right – will be stock selection. Once headlines no longer drive markets, the stark differences between sectors and shares should enable stock-pickers to eke out better returns than investing passively, especially in some markets still beset by challenges, like the UK, Europe and Japan.
However, we would caution that our crystal ball may remain cloudy until some of the policy moves mentioned above (the Fed, the US-China trade deal) actually happen, or at least are sufficiently clear for markets to discount them. This indicates that some degree of patience may be needed during 2019 and that the market will not be as smooth or uncomplicated as 2017.
Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.
The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.
The information contained herein is based on materials and sources that we believe to be reliable, however, Canaccord Genuity Wealth Management makes no representation or warranty, either expressed or implied, in relation to the accuracy, completeness or reliability of the information contained herein. All opinions and estimates included in this document are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information contained herein.
Chief Investment Officer
Michel is responsible for the investment process at Canaccord Genuity Wealth Management, with a specific focus on asset allocation and stock selection. He also works to maximise the potential of Canaccord Genuity’s proprietary and industry-leading stock screening tool, Quest®.
Michel is an experienced investment strategist having spent the past 19 years at JP Morgan Private Bank where he was the Chief Investment Strategist (EMEA) responsible for running investment strategy and overseeing tactical asset allocation decisions for discretionary portfolios within the region.