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Bull-and-Bear Tug of War Hangs Over Markets

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The U.S. economy is moving into a late cycle phase after almost 10 solid years of growth, but according to strategists at T. Rowe Price that’s no reason for investors to panic.

“A late cycle can last a long time,” said Andy McCormick, head of U.S. Taxable Bond at T. Rowe Price global market outlook press briefing. “It doesn’t necessarily lead to recession.”

Alan Levenson, the chief U.S. economist of the Baltimore-based mutual fund firm, expects U.S. growth will slow from 3% this year to 2.25% next year, but he doesn’t expect a recession before at least 2020. By then Fed tightening, a flat yield curve and fiscal stimulus, which will still boost growth in  2019, will become headwinds for the economy, said Levenson.

Levenson expects the Fed will hike another 175 basis points, which would push the Fed Funds rate up to a range of 3.75%-4%, well above the 3.4% median forecast of Fed policymakers, according to the St. Louis Fed, and of other Wall Street economists. “2020 will be a period of greater risk to the economy,” said Levenson.

(Related: 3 Ways to ‘Bear-Market Proof’ Your Business)

Fear that the Fed will go too far in tightening monetary policy coupled with fears of a “potential trade war with China” has been driving the recent downturn in stocks, said John Linehan, chief investment officer of U.S. Equity Value at T. Rowe Price. The S&P 500 has lost 7% since the last week of September.

He noted that the 10-year bull market has had “the most robust earnings recover ever” while the economic recovery is “probably the most tepid” post-World War II, which suggests it probably has more room to run.

“Bull markets don’t die of old age but economic downturns or speculative excess,” said Linehan. The U.S. stock market hasn’t experienced either in the current cycle.

Linehan said the U.S. stock market is “setting up a backdrop for value to begin working,” after years of underperformance compared to growth stocks. “Over the next three to five years the prospects for value look good,” said Linehan.

In the meantime U.S. stocks will be caught up in a tug of war between bearish factors and bullish factors, said Linehan. On the bearish side are Fed tightening, potential trade war and rising corporate, consumer and government debt. On the bullish side, strong economic growth with historically low inflation, strong consumer and business confidence, earnings growth, innovation and a  supporting electoral cycle.

Also supportive is the presidential cycle, said Linehan. The S&P 500 typically posts the strongest performance in the third year of a presidential term and its six-month return following a mid-term election has averaged 17% since 1940, according to Linehan. Asked if that trend will hold during the term of a president who is unlike any other before him, Linehan said that Donald Trump will  want to adopt policies that could boost the economy in order to support his re-election.

Linehan expects a choppy U.S. stock market next year, still bullish but with rising risks. The tug of war between bullish and bearish factors favors opportunistic strategies and bottom-up stock selection, said Linehan.

Certain bond markets, like selected U.S. stocks, should also do well late cycle, said McCormick. He favors bank loans and collateralized loan obligations, whose rates adjust higher with rising interest rate as well as emerging market debt, which is relatively cheap following a big selloff. Both bank loans and emerging market debt tend to perform well toward the end of a rate tightening cycle, but McCormick noted that he is more selective now when choosing bank loans because of the decline in the quality of  loan covenants.

Emerging market bonds could also benefit from another market factor that T. Rowe Price portfolio managers are expecting for 2019, namely the peak in the value of the U.S. dollar. The rising dollar has had a negative impact on dollar-denominated emerging market bonds because that debt becomes more expensive for those borrowers to repay.

The U.S. dollar needs to fall or interest rates need to rise to attract investors to fund an increasing U.S. deficit, said Justin Thomson, Chief investment officer, International Equity. The deficit increased 17% to $779 billion in the last fiscal year and began the current fiscal year with a $100 billion deficit in October.

The performance of U.S. financial markets next year and in years to come will reflect not only cyclical changes but also secular risks, said David Giroux, chief investment officer, U.S. equity Multi-Discipline, who was recently named to the newly created head of investment strategy post. These emerging disruptive forces in the economy affected 20% of stocks in the S&P 500 two years ago and now impacts 30% of the index, said Giroux, noting he expects that percentage to rise another 13% over the next three years.

“It’s hard to outrun secular risk,” said Giroux. The only certain sectors that will be able to do that, said Giroux, are utilities and industrials, including defense,  business and information services and the secular disruptors such as Amazon, Netflix and Google.

Asked which sectors and companies are most vulnerable to secular risk currently,  Giroux said cable companies, hardware companies, ad agencies, grocery stores, shopping malls and consumer staples including food companies and household product manufacturers – all affected by disruptive developments, largely technology-based.

Secular risks also pose challenges for value investors as the universe of stocks become more tilted toward economically cyclical stocks and for passive investing vehicles, said Giroux.

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