Our Perspective on Recent Market Events

01.02.2019 - Ronald J. Sanchez, CFA

A 'Crisis of Confidence' Ushers in The New Year

It has been a challenging few weeks for the markets--financial conditions have tightened; interest rates are on the rise and markets have come under intense pressure as the headlines surrounding trade and monetary policy take their toll on investor confidence.  

We continue to closely monitor market conditions and, despite these events, believe the recent shift in sentiment has been driven more by technical factors than fundamentals. In other words, we are experiencing a "crisis of confidence" among investors rather than an impending economic crisis. 

Below is our perspective on recent market events.

How Did We Get Here?

The S&P 500 peaked at the end of September 2018, but since that point has nearly turned into bear market territory after declining by almost 20%. It lost 15% in December, recovered, and ended the year down 4.4%. Moreover, intraday volatility has been wrenching, with US equities moving by more than 2% on 22 occasions in the fourth quarter of 2018. For context, there were zero moves of that magnitude in all of 2017.

This type of shift in market behavior is typically associated with an unexpected change in macroeconomic conditions or deteriorating corporate fundamentals. Instead, markets appear to be overwhelmed by questions surrounding trade policy between the US and China, and concerns over the path of monetary policy.

These two policy issues have been in the headlines for most of 2018, so they aren't new to investors. What has changed is investor perception, which has contributed to a sudden and dramatic re-rating (change in valuation) of markets across the world.

While the US equity market has experienced its fair share of pullbacks since the Great Recession began in 2008, it is difficult to recall any that were as abrupt and undiscriminating as this experience. Like a pendulum, investor confidence swung from seeing the glass as full to seeing it as completely empty, all at lighting speed. 

Optimism has been replaced with uncertainty, and increased uncertainty has led to greater variability in outcomes, resulting in increased risk and a higher risk premium (the rate of return an investor expects to receive for risk). The market has taken a sharp turn, dragging valuations down to levels we have not seen since 2013. This re-rating of capital markets implies that investors expect the global economy and corporate earnings to nose-dive.

However, according to Bloomberg consensus forecasts, global economies are expected to expand by 3.7% in 2018 and by 3.5% in 2019. Notably, the US has been a major driver of global growth, and while not immune from the cold that seems to be afflicting markets, it continues to expand at above-trend rates with the best growth in a decade. Unemployment is at its lowest level since the 1960s, wages are increasing at over 3%, inflation remains modest, and both business and consumer confidence remain robust. Recently reported holiday sales for 2018 were the best in six years, even when measured against 2017 when consumers were spending in a substantial way as they recovered from consecutive hurricanes.

Additionally, as we wrote over the course of 2018, corporate earnings are expected to wrap up 2018 with growth of over 25%, according to current Bloomberg estimates. This pace likely cannot be sustained, but markets seem to be pricing in expectations of zero earnings growth in 2019. Our belief is that earnings will moderate, but likely remain modestly positive. While many outcomes are possible, as a point of reference, if earnings growth is flat next year, that would imply a level of 2330 on the S&P 500 with the price-to-earnings ratio at 14.4 times. For comparison, the S&P 500 closed at 2351 on Christmas Eve.

What Really Changed?

If fundamentals continue to appear supportive, at least in the US, what changed? Clearly, sentiment took a turn for the worse in early October, when the tug-of-war between fundamentals and policy uncertainty moved more towards the uncertainty camp. Investors have known for some time that the Federal Reserve has been unwinding its accommodative policy and intended to keep doing so over the course of 2018. Market participants also have been aware of the "unknowns" associated with trade policy for the entire year.

Until recently, solid economic and earnings data, supported by fiscal stimulus, have encouraged investors to continue buying throughout the dips, propelling US equities to their highest levels on record. Investors optimistically assumed that policy issues would resolve themselves. But weening markets off central bank liquidity is never an easy proposition, especially when it appears we have already reached the peak of economic and earnings growth.

Statements by Federal Reserve Chairman Jerome Powell spooked markets early in the 4th quarter of 2018. Combined with increased trade policy uncertainty, skepticism towards the US fundamental backdrop, Brexit and other geopolitical uncertainty, slowing growth in Europe and China, and a US government shutdown, markets turned in an ugly end to an otherwise fundamentally encouraging year. The most hated bull market in history finally met a confluence of factors that turned even the most optimistic investors into "sell-the-rally" players.

We believe we have left market nirvana and entered a more historically normal environment--one that does not provide the level of certainty we have grown accustomed to. Markets are recognizing this return to normal after a decade of global monetary accommodation and full transparency on forward guidance from the Fed. We are in the unfamiliar position of having a greater degree of unpredictability--a data-dependent world that has reintroduced investors to high levels of volatility and tail risk. This transition has been painful, to say the least.

Our Perspective

Given the heightened level of uncertainty, a healthy dose of skepticism regarding the performance of the economy and markets is warranted and even healthy for markets. However, the recent pullback reflects a shift in sentiment that appears more technically-driven than fundamentally rational. We believe we are experiencing a crisis of confidence as opposed to an impending economic crisis. Although perception can become so negative and pervasive that it becomes a self-fulfilling prophecy, we believe the odds are narrow that it meaningfully slows economic growth, and at this point there is little evidence to support a rapidly deteriorating economy and impending recession in the US.

Market price action leaves us feeling like we are in a prolonged bear market and is signaling the end of this cycle. Although disappointing, the year-end market reset has lowered the bar meaningfully for the upcoming year, meaning we see more upside than downside from current levels. Our base case is that the US economy likely moderates, growth outside the US stabilizes, earnings growth will be modestly positive, and inflation and rates remain well behaved. Given the growth in employment, wages and the corporate sector benefitting from tax reform and strong cash flow, in addition to a well-capitalized banking system, we feel confident in economic fundamentals and believe the US will grow at a lower, but reasonable, trend pace.

With the price-to-earnings ratio on the S&P 500 now inside of 15 times and an elevated level of pessimism, we see limited scope for further downside and expect markets to likely recover in 2019. In fact, if we were to see some positive developments on the trade front or some clarity regarding monetary policy and economic data, we could see an upside surprise as investors who have bolted over the past three months regain some confidence and return to the market.

Kyle Baker, CFA, Vice President, Senior Investment Associate, contributed to this article.

This communication is intended solely to provide general information. The information and opinions stated are as of January 2, 2019 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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