March 2019 Perspective: Economic and Investment Outlook

03.18.2019 - Ronald J. Sanchez, CFA

There's Nothing Normal About This Normalization

A roaring start to 2019 saw the S&P gain 7.9% in January, its best start in 32 years. The Dow posted gains for nine consecutive weeks. Include February, and the S&P and Russell 2000 had registered returns of over 11% and 20% respectively. Markets are roaring.

But not so fast. Instead, we prefer to look at the US equity market move in the context of what has been a wild ride since the fourth quarter of 2018. Its heightened twists and turns began in October before culminating in December’s troubling swoon. In fact, the market drawdown of 9.2% during December was the worst for that month in nearly ninety years. The fourth quarter, with December’s price action the leading contributor, stumbled into year-end returning -14%, the worst fourth quarter performance for the S&P 500 in a decade.

Clearly through this lens, 2019’s performance can be viewed as an astonishingly rapid V-shaped recovery. So, what is driving this hasty shift in sentiment? How can voices on financial television be shouting “bear market” one day and “bull market” the next? Who is right?

Policy Crossroads

In our thinking, the way to constructively proceed is to instead think about what is causing the intensified price action. We view investors as forced now to quickly sort through a stack of critical questions on three policy fronts:

  • Monetary Policy
A normalization program following a decade of zero interest rates post-Global Financial Crisis, including an asset-purchase program (quantitative easing) that grew the Fed’s balance sheet by more than $3 trillion, that had seen the Fed hike interest rates nine times in four years, including four times in 2018. 

  • Fiscal Policy
The most significant tax reform package in decades along with the budget providing for substantial spending increases saw fiscal policy provide an extra gear to an economy already performing well, as well as questions centered on how long the boost to growth would last. 

  • Trade Policy

The administration remade US trade policy which hadn’t been modified for decades, and it did so in dramatic fashion. This stoked fear of a full-blown trade war, as China and Europe were threatened with sweeping tariffs, NAFTA was renegotiated, and the administration embraced a more unilateral approach to negotiations. 

All told, the government policy trifecta of trade, fiscal, and monetary individually carry inordinate potential impact on the economy in normal times, let alone times like these that are anything but ordinary. When in combination these policy risks intensify, we have a formula for rapid shifts in market sentiment irrespective of changes in economic fundamentals.

Enacting expansionary tax reform and other stimulative measures late in an extended economic cycle and renegotiating decades-old trade agreements and practices are both undoubtedly complicated. Combine that with dogged progress by the Fed in its attempts to normalize monetary policy and it can quickly get messy, as we just experienced. This level of policy uncertainty is manageable for the market if the economic backdrop remains rosy. However, as we are seeing with global slowdown fears, this intersection of policy risks has forced the market to weigh an ever-higher number of possible outcomes. 

Monetary Policy: Disappointment then Delight 

In December, the market evaluated potential outcomes and pivoted to embrace the worst-case scenario. This came on the heels of a Federal Reserve that seemed stubbornly hawkish despite a clear slowdown in the global growth backdrop. The Fed, following through with its fourth rate hike in 2018, further spooked market participants.  As we turned the calendar to 2019 and markets rebounded, we didn’t have to look far to find a catalyst.

Early in January the Fed clearly shifted its tone and signaled a new stance on monetary policy. This dovish turn was further boosted by stronger domestic economic data, resilient corporate earnings, stimulus in China and a more constructive tone on trade negotiations. Investors began to recalibrate their expectations and quickly priced out the worst-case scenario of the prior month.

Now that the year-to-date V-shaped recovery has propelled the S&P 500 back to within 5% of its all-time highs, we are left to grapple with what caused the wild swings. The answer seems that monetary policy concerns were the common thread in the intense market selloff and despite the questions and concerns regarding fiscal and trade policy, even all these years after the financial crisis, the market remains centered on the Fed. Market sentiment is closely aligned with Fed policy guidance, so how did the Fed and markets fall into disagreement before harmonizing again?

Lights Out: Fed Maneuvers in the Dark

Monetary policy reasserting itself is unsurprising at a time when the Fed is navigating uncharted waters on its journey toward normalization. With no comparable regimes to use as a point of reference, the Fed is essentially working without any historical context, which has kept markets on edge.

Fed chairman Jerome Powell described the situation best when he compared the central bank’s challenge to “walking through a room full of furniture” without any lights turned on. Naturally, investors are more cautious than ever about what the Fed might do next. 

The Fed Stumbles on the Furniture  

As the Fed “feels the furniture” to maneuver through normalization, its guidance has not always been consistent or reassuring for the market.  

Specifically, last October Powell suggested the Fed still had a long way to go before reaching a neutral policy rate. This implied that further tightening could be expected and pressured the equity market lower. However, just one month later, he reversed course and suggested the Fed might take a less aggressive approach, sending the market soaring. 

Next, the minutes released after the FOMC’s December meeting seemed broadly hawkish, once again heightening concerns about rising rates. To make matters worse, those minutes made no mention of the deteriorating economic condition outside the US, leading some to wonder if the Fed was overlooking the importance of interconnected international markets to US economic growth.  

The Fed’s lack of clear guidance on policy normalization frustrated investors and culminated in dramatically lower markets which bottomed on December 24th. Investors began to seriously discount the possibility of a Fed policy error, and in turn the potential for a Fed-driven recession. Clear evidence of this was seen in the pricing of futures contracts, where by the end of December markets were predicting the next Fed rate decision to be a rate cut, not a hike. Only a few weeks prior, investors were expecting two rate hikes in the next 12 months (CHART 1). 

The Fed Stops Moving 

During the first week of January, Powell acknowledged the market’s skittishness. He stated the Fed was “listening sensitively to the message that markets are sending.” That set the tone for an onslaught of communications from Fed speakers reinforcing an idea of the Fed hitting the pause button. The path to normalization of interest rate policy would wait. 

Markets, buoyed by having the Fed once more on their side, shot higher (CHART 2). The fact remains that despite their best intentions to get back to normal, the Fed, to a heightened degree, remains at the center of the story. 

What Happens Next?

As the dust settles, it’s clear that investors have struggled to find the correct level for equity prices in an environment of slowing global growth and turbo-charged policy. As we wrap up February, the market is not far from its September 2018 all-time highs. While our low-single-digit return forecast for 2018 was ultimately off the mark, incorporating January and February gives a 14-month return of 6.3% for the S&P 500. Admittedly, this is an unconventional timeframe, but the thought exercise is useful and paints a picture that reconciles to our expectations of modest market returns and reasonable economic and corporate fundamentals.

Accordingly, the lesson is not to overreact to wild price swings during periods of heightened volatility. The pause in Fed tightening and some positive developments around trade negotiations with China has led investors to feel a sense of comfort around valuations. The silver lining with the recent volatility is that it has perhaps led policymakers to reassess the unconventional tactics they’ve used in trade negotiations thus far, creating another sort of policy “pause” in addition to the Fed.

After this reset, we expect further price appreciation to be modest, but the extremes like in December look to be behind us. Risks appear to be more accurately priced into markets. We acknowledge our place in the advanced stages of this economic and business cycle and recognize the threat from slowing global growth potentially spilling over into the US. However, we continue to see counterbalancing forces from the consumer with continued strength in labor markets and the potential for second order effects of tax reform via increases in capital expenditures.

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 March 18, 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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