Turning the Page

Peter 2017-04.jpg

by Peter Jones, CFA
Vice President of Research

As we look back on 2018, we can summarize the year as one where volatility emerged at the same time equity markets and the economy diverged enormously. In fact, 2018 is estimated to produce the strongest economic growth since the Global Financial Crisis at 3.0 percent. On the other hand, the S&P 500 is set to decline around 5 percent including dividends, the worst and only negative return in the current expansion.

Source: FactSet

Source: FactSet

While this discrepancy may seem puzzling, equity markets are discounting mechanisms, or leading indicators of future economic activity, rather than the reflection of the current economic state. Thus, the sharp pullback we’ve endured in the fourth quarter implies a slower economy in the coming years.

Although the direction of equity markets often forecast future economic activity, stocks are notoriously more volatile than the underlying economy and tend to overshoot on both the upside and the downside. As we move on to 2019, we too see a slowing economic picture, but are hard-pressed to find any signal that growth is set to contract. Rather, slowing growth can largely be attributed to fading fiscal stimulus and a stronger U.S. Dollar, rather than weakening corporate or consumer fundamentals. To that end, we view the recent market turmoil as an “overshoot,” rather than a signal that we are on the brink of recession. The largest component of the global economy, the U.S. consumer, remains in very good shape. Employment is strong, incomes are growing, debt levels are modest and confidence measures remain at levels supportive of solid spending. At the same time, inflation is benign, allowing the Federal Reserve to be pragmatic in setting monetary policy.

Nonetheless, with the Fed raising interest rates, inflation rising and unemployment sitting at 40-year lows, we are undoubtedly closer to the end of the expansion than the beginning. However, the final stages of economic expansion often provide equity investors with very strong returns.

Source: JPMorgan

Source: JPMorgan

With equity valuations sitting at attractive levels, corporate earnings set to rise and strong returns in the later stages of economic expansions, we believe we will have the opportunity to reduce risk from higher levels.

Week in Review and Our Takeaways

  • After posting the worst ever Christmas Eve return on Monday, U.S. markets rallied sharply after Christmas, with the S&P posting its largest percent gain since 2009 on Wednesday

  • Bond markets were calm with the 10-year roughly flat

  • 2018 was marked by the strongest economic growth against the weakest equity returns of the current expansion

  • Equity markets tend to lead economic growth, but we think the market’s decline is much steeper than the coming growth slowdown and thus see upside in 2019

  • Equity returns are often very strong in the final stages of an expansion