There is little doubt that the equity markets took investors on a wild and volatile ride in 2018. After the market reached an all-time high in September, a number of political and economic concerns led to a market sell-off in the fourth quarter, when the S&P 500 declined nearly 20 percent from its September highs and – 4.4 percent for the 2018 calendar year.¹
With the start of a New Year, investors with stock exposure are asking if they have the appropriate amount, and, given the uncertainty of the current political and economic environment, should they reduce their exposure at this time. On balance, PWA believes that the economy remains strong and that the current expansion can continue. With that said, it is a close call as economic growth is expected to slow. Therefore, we have made some defensive moves in our discretionary portfolios to protect against a broad range of potential risks and further market volatility.
For the purpose of this market outlook, it is critical that clients view the current economic and market data in the context of their unique portfolio strategies that align with their equally diverse individual financial goals and objectives. Given the length of the economic expansion and where we are in the business cycle, predicting economic conditions going forward will become more challenging.
To best frame investment decisions, we must narrow our focus on the key factors that affect the strength of the economy and expected returns for investable assets going forward. While this outlook focuses on several issues that we feel are most important, we are continuing to monitor other domestic and global concerns that will affect markets and our client’s portfolios.
Consumer spending, which accounts for roughly 68 percent of the U.S. economy, is perhaps the single most important factor to consider when gauging the strength of the economy. In fact, stable or rising levels of consumption can counterbalance and offset other potential concerns elsewhere.
Two critical components that drive consumer spending are the labor market and wages. By many measures, the labor market is the strongest it has been since the start of the current economic expansion. According to the most recent jobs report, the economy added 312,000 jobs in December of 2018, 136,000 more jobs than expected. The number of job openings is currently greater than the amount of people looking for work, and, while initial jobless claims increased slightly in December, they remain 40 percent below the level of jobless claims that preceded prior recessions.²
Wages grew 0.4 percent in December 2018, or 3.3 percent over the prior year. More importantly, wages are growing at a faster rate than inflation, providing households with significantly more purchasing power. According to data from the Federal Reserve, household net worth as a percentage of disposable income reached an all-time high the third quarter of 2018, demonstrating that households are in a much better financial position today than they were prior to the recession that began in December of 2007.³ Moreover, the tax cuts that went into effect on Jan. 1, 2018, and recent declines in gasoline prices should provide consumers with an additional boost to an already strong financial picture.
Finally, while recent data from The University of Michigan and The Conference Board reported that consumer confidence has softened somewhat recently, both remain at historically high levels. Given the tight labor market, rising wages, and improved household finances, we expect that consumer confidence will remain elevated and continued gains in consumption will drive the already long economic expansion further.
Historically, aggressive tightening of monetary policy has created economic headwinds, undermined the strength of the labor market and led to recessions. Given this relationship, one of the primary concerns troubling markets is the fear that the Fed may be raising the benchmark interest rate too quickly. These concerns escalated at the Fed’s December meeting, when it raised rates a quarter of a percentage point for the fourth time in 2018, and Chairman Jerome Powell stated that he “expects” to raise rates two times in 2019 despite market concerns.
By raising interest rates, the Fed is trying to cool the economy but not so much that a recession occurs. While engineering this sort of economic “soft landing” has not been very successful in the past, the other option is not optimal either. Should the Fed keep rates too low for too long, it runs the risk of overheating the economy and creating a severe recession that is more difficult to manage down the road.
The Fed’s job will be difficult in the months and years to come. Given that markets are forwarding looking and always digesting information, markets can jump to conclusions when new data on the economy becomes available. Nonetheless, we believe the Fed continues to err on the side of caution as measures show that the current fed funds rate is still below neutral. And, while the recent increases may slow the economy somewhat now, they are likely to extend the expansion, reduce the magnitude of the next slowdown, and give the Fed more room to maneuver when the next slowdown occurs.
The Challenges with China
The ongoing trade war between the U.S. and China escalated in 2018 as the U.S. sought to correct what it considers to be unfair Chinese trade practices and to protect intellectual property, forced technology transfers, and access to China’s market. While it can be argued that there are signs of progress on the horizon, it is important to note that tensions between the two nations will continue, especially as China pursues its five-year-old One Belt One Road foreign trade initiative, partnering with other nations and increasing its influence over those regions. Tensions between the U.S. and China are unlikely to go away any time soon, but we do not expect them to deteriorate further from current levels.
The second concern with regard to China is that of its economic growth irrespective of the issues associated with trade. Recent data shows that China’s economy is certainly slowing, prompting fears of a significant slowdown. While the U.S. is relatively insulated from economic conditions in China, there would implications here given that China has risen to the world’s second-largest economy. While the current concerns over China’s economy is warranted, Chinese officials are still targeting growth of 6 to 6.5 percent in 2019. With growth expected to be the lowest since 1990, policymakers have been taking measures to stimulate the economy with additional tools at their disposal should growth weaken further. ⁴
With a price return of -6.2 percent (or -4.38 percent total returns once dividends are considered), last year marked the S&P 500’s worst returns since 2008.⁵ More concerning was the 20 percent decline the index experienced in the fourth quarter from the highs it reached in September, which evoked memories of the financial crisis and the dot-com bubble before that. While we cannot rule out the prospect of further market declines, we continue to believe that equities will produce more attractive returns than alternatives, such as bonds and cash.
For perspective, from 1950 to 2018, the average annual return on stocks was 11.1 percent, while the return on bonds was 5.8 percent.¹ That’s an excess return of 5.3 percent. Over that same time, stocks experienced 12 declines of more than 20 percent and 41 corrections, between -10 percent and -20 percent.⁶ Therefore, while market declines can be uncomfortable and worrisome, equities have proven to be a smart choice over the long term.
Similarly, while we have taken some precautionary moves in our discretionary portfolios, we do not believe it is prudent to abandon equities in the short term during the current economic climate for the following reasons:
1.Equity valuations have improved significantly, given strong earnings growth of 20.3 percent expected for 2018 and recent price declines. For perspective, at the beginning of 2018, the Forward P/E stood at 18.8. Today it stands at 14.4. In other words, stocks are currently 22 percent cheaper relative to earnings than they were one year ago, and 10 percent cheaper than their historical averages. ¹ Source: JP Morgan
2. As mentioned in our prior communications, we believe the current pullback is more of a correction than the beginning of a bear market, which commonly occurs in line with recessions. While we do not believe a recession is imminent, we will continue to monitor developments and make adjustments to discretionary portfolios as needed
3. It is important to consider alternative options or substitutes for equity investment dollars. For example, the yield on short-term bonds or money market funds has recently attracted substantial capital from investors. While these instruments have minimal exposure to market or interest rate risk, dollars invested here will merely keep pace with inflation and not grow real wealth.
Despite the recent volatility faced in the equity markets, equity valuations are far more attractive than they were just several months ago. Assuming the economy avoids recession, we continue to believe stocks can add value when they are properly aligned with the investor’s goals and objectives.
Fixed income will always be a critical component of a well-diversified portfolio. For investors who are currently or close to relying on their portfolios for income, exposure to and proper positioning is critical at this stage of the cycle. That being said, given the current market environment, and more specifically the flatness of the yield curve, bonds are not expected to provide particularly attractive returns going forward. For context, the yield on a one-year treasury is currently 2.557 percent, whereas the yield on the 10-year treasury is 2.659 percent. As we all know, bond prices move inversely to changes in interest rates. With a roughly 0.102% additional yield, we do not believe that the added yield is commensurate with the additional interest rate risk that comes with longer term bonds. ²
As we start 2019, there is no shortage of uncertainties. While economic growth is likely to slow, it does not necessarily signal that a recession is imminent. We believe continued gains in consumer spending, a patient Fed and improvements in China and our trade with the country will calm concerns.
Given the length of the economic expansion and where we are in the economic cycle, forecasting growth going forward will be particularly challenging. While equities are likely to remain volatile, we do believe they can continue to provide attractive returns when they are used appropriately as part of a strategy designed to meet individual client’s unique goals and objectives.
About the Author: Joseph Karl, CFA, is head of research and senior portfolio manager with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors and Accountants, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
Provenance Wealth Advisors, 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investments mentioned may not be suitable for all investors.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Past performance may not be indicative of future results. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. The above hypothetical examples are for illustration purposes only. Actual results will vary. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions. Diversification does not ensure a profit or guarantee against a loss.