This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.
'Tis the season to wish for more of all three!
Unfortunately, we aren't getting much cooperation from stock and bond markets on the peace front as we close out 2018. Stocks have had the worst performance during December than they've had in this month for decades. Bond yields have dropped precipitously from their recent highs as investors flock to safety and worry about future economic growth. Perhaps unraveling what's going on will help all of us enjoy the season more.
There is little peace in markets today. One reason for the recent consternation has to be the fact that markets lacked volatility in 2017. Remember when we were setting records regarding the number of days without at least a 1% up or down move? The stock market's volatility index remained near 10 for most of last year. More recently it has spiked above 20, and within the last several days has traded as high as 30. There are several reasons for this volatility.
First, and most importantly, investors are re‐evaluating their mid‐summer optimism regarding U.S. economic growth. In July, it was reported that the U.S. economy grew by more than 4% for the second quarter in a row. This was more than double the 10‐year average growth rate. Fueled by the tax reform in late 2017 and an improvement in revenue and earnings growth, stock investors bid prices up to reflect that higher level of growth.
However, while the economy can do better, the base rate of growth is still near 2%. We believe we're seeing an adjustment to expectations back to that level. Stock investors are wont to push prices too far in either direction though, so the euphoric level seen in late summer and early fall has given way to lower prices.
The estimate for earnings growth next year for the S&P 500 Index is $173.49. Given the current level of the S&P 500 Index, the market trades at just over 14 times earnings, not the 18 times earnings we saw three months ago. Of course when investor sentiment shifts to negative, as it has in the last eight weeks, the assumption is that the $173.49 in earnings for 2019 won't be realized. Interestingly, despite the 16% decline in stock prices, earnings estimates have fallen only 2% in the last month.
Back to investor sentiment. One way to measure it is to look at the AAII Bull/Bear index of sentiment. The bearish index jumped 60% in three weeks. This means investors are looking for reasons to sell, not buy, and that puts additional downward pressure on prices. However, it doesn't change the fundamentals.
Another place lacking peace is Washington D.C. As recently as yesterday, we had talk of a government shutdown, the resignation of the Secretary of Defense and the normal partisan wrangling that takes place post mid‐term elections.
Unfortunately, with the change in sentiment, that puts additional downward pressure on stock prices.
Earnings expectations will likely drift lower and economic growth will be slower in 2019. However, if investor sentiment gets too negative for too long, we are likely to see an opportunity to move additional capital into global equity markets. Here's why we think that's the case.
This week, the Federal Reserve raised the short‐term interest rate by .25%. In addition, during its press conference, the Fed indicated that it would likely keep hiking rates in 2019 and continue reducing the size of its bond portfolio.
Markets were hoping for less bah humbug from the Fed chairman, but that didn't happen. So what's to love about that? The Fed did reduce its proposed number of hikes in 2019 by one and emphasized the fact that it is very “data dependent.” That means it will closely watch for signs that its higher interest rate policy is slowing the economy below the 2% growth rate. We may love that later in 2019 because as the Fed ends its hiking cycle, markets usually begin to perform better.
The yield on the 10‐year Treasury has fallen from a high of about 3.25%, to today's 2.76%. This means interest rates are only about .25% higher than they were at the beginning of the year. Investors in this part of the bond market are saying that they believe inflation will not accelerate and growth will return to a more normal rate. For my money, bond investors usually get the economic call right or at least do better than stock investors.
As we turn our attention to 2019, some of the hope will come from China. The Chinese economy is the second largest in the world and drives much of the global economic growth rate outside of the U.S. Because the rate of growth has slowed considerably in China, they have lowered their interest rates by 50%, reduced tax rates on individuals and corporations, reduced their anti‐corruption measures and used other monetary policy means to stimulate growth.
All of this has taken place in the last nine months. And just like the interest rate hikes by the Federal Reserve took one to two years to slow growth, the Chinese policies will take a similar amount of time to have a positive impact. By the end of 2019, we may see the impact, and asset prices will begin to reflect the better pace of growth.
However, we don't invest based on hope. We invest based on facts. From where we sit, the facts are that economic growth is slowing to a more normal rate for our economy. The facts are that much of the U.S. and international stock market is substantially cheaper than it was three months ago. While earnings will likely also decline, the reality may not be as negative as investors are currently seeing. We don't see coal at the bottom of the stocking, and we don't see a new Porsche either (so that's my wish this year!). A return to a more stable environment with elevated levels of volatility from geo‐politics and trade talk are what we expect in 2019.
From all of us at Johnson Financial Group, we wish you more peace, love and hope throughout the holiday season and into the new year.
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