Market volatility in December tested the emotions and confidence of even the most experienced investors. The resignation of James Mattis as secretary of Defense, rumors that President Donald Trump would fire Federal Reserve Chair Jerome Powell and the shutdown of the U.S. government were unwanted gifts for investors hoping for a restful holiday season.
The market may have overreacted to the latest developments in a turbulent year, and December’s market slide is more likely to be a pause in the bull market rather than the start of an extended bear market. Government shutdowns are becoming a more frequent occurrence, and this shutdown may end shortly into the new year. It is unclear whether Trump can legally fire Powell, and doing so would meet with opposition from both Democrats and Republicans on Capitol Hill. Fed policy wouldn’t likely change if Powell were removed from office, as the remaining members of the Board of Governors would be united in defending the independence of the central bank.
The primary drivers for the market outlook are expectations for economic growth, interest rates, and trade policy.
Economic growth is slowing from the rapid pace of the first three quarters of 2018. Global manufacturing indicators are weakening, a consequence of uncertainty about trade policy and slowing economic growth in China. Manufacturing growth continues to expand in most of the world, albeit at a slower pace. China is a notable exception, however, with the most recent data signaling a slight contraction in manufacturing activity.
The housing market has also lost momentum. Although home prices have been rising, indicators such as housing starts and mortgage applications are uninspiring. Rising interest rates, tax changes reducing the desirability of homeownership, and a shortage of entry-level homes are among the factors contributing to the housing slowdown.
Falling oil prices contributed to December’s market volatility, as investors worried that oil prices were a signal of collapsing economic growth. The fall in oil prices has more to do with an abundance of supply rather than a shortage of demand. The Trump administration granted waivers of sanctions on Iranian oil exports to eight major importers, which effectively added more than 1 million barrels per day to the global supply of oil.
The American consumer provides a considerable counterweight to the bad news of recent weeks. Consumers are benefiting from a tight job market, long-overdue wage increases and healthy personal balance sheets. Solid retail sales this holiday season and a blockbuster employment report for December offsets much of the negative news elsewhere in the economy. Overall, although U.S. economic growth will slow from the rapid pace of the first nine months of the year, fourth-quarter GDP growth is projected to remain above-trend for this economic expansion.
The Fed raised interest rates four times in 2018. Second-guessing the Fed is a popular pastime, but Trump is overstating the degree to which the Fed is to blame for the economic slowdown and market downturn. The Fed’s actions are consistent with the mandate to promote maximum employment, stable prices and moderate long-term interest rates. From the Fed’s perspective, tight labor markets are creating long-overdue wage growth, fiscal stimulus may contribute to inflationary pressures, and tariffs may be inflationary in the short term.
By raising rates to at least a “neutral” level and shrinking the Fed’s balance sheet, Powell is trying to regain the flexibility necessary to support the financial system during the next recession. The Fed is also aware that past periods of “easy money” gave rise to excesses in commercial and residential real estate, technology and commodities. However, the downturn in equity prices and widening of corporate credit spreads relative to government bonds seem to make that task less critical. Slowing growth and the flattening yield curve may cause the Fed to hit the “pause button” on rate hikes in 2019.
Trade policy has far-reaching implications for economic growth and market sentiment. Although U.S. companies were expected to boost capital spending in response to corporate tax reform, business spending has fallen far short of expectations. Trade tensions create uncertainty about input costs, supply chains and potential tariffs, diminishing the enthusiasm of corporate CEOs to initiate capital spending projects. The announcement of plant closures and job cuts by General Motors (GM) highlights the challenges faced by many American manufacturers and the disconnect between political promises and economic realities.
The disconnect between politics and economics is particularly important in the debate about trade with China. China’s economy grew at the slowest rate since 2009, with reported third-quarter 2018 GDP growth of 6.5% (and private-sector estimates lower than the official GDP number). Despite some of the claims made by policymakers in Washington, China’s economy is not collapsing and slowing growth has more to do with credit tightening designed to curtail “shadow banking” activities than with tariffs imposed by the U.S. Net exports now represent only about 2% of Chinese GDP, with exports to the U.S. representing less than 20% of total Chinese exports. China is softening the impact of tariffs on exporters by allowing its currency to depreciate, and will continue to take action to bolster economic growth.
Marko Papic, geopolitical strategist for BCA Research, offers a helpful framework for thinking about geopolitical issues. Papic believes that geopolitical decisions are shaped by constraints rather than preferences. Although Trump might “prefer” to escalate trade disputes with China and Europe for the remainder of his first term as president, he ultimately will be constrained by likelihood that a protracted trade war will create higher unemployment and lower economic growth. Although there is likely to be a “grand bargain” with China on trade before the 2020 election, the next year may be filled with periods of hope and despair much like that experienced in the days following the Trump/Xi dinner at the G20 Summit in December.
The most likely scenario for 2019 is a growing but slowing economic environment. Compromise on trade and a pause in interest rate hikes would would likely be a catalyst for a relief rally in many of the segments of the market that have struggled in 2018.
The steep downturns of 2000 and 2008 remain fresh in investor thinking. However, there are few parallels to the major bear markets of 2000 and 2008, as well as to the early 1970’s bear market. In comparison to 2008, there isn’t a real estate bubble, bank leverage is far lower than was the case a decade ago, and regulators have considerably more visibility into derivatives usage. Equity valuations are far from the distorted levels of 1999, and capital spending has been far more muted. Unlike the 1970s, inflation remains under control, with oil prices falling and wages rising moderately despite tight labor markets.
Oaktree Capital’s Howard Marks has relevant advice for investors tempted to hide in cash: “Move forward, but with caution. The outlook is not so bad, and asset prices are not so high, that one should be in cash or near-cash. The penalty in terms of likely opportunity cost is just too great to justify being out of the market.”
— Check out Howard Marks: ‘Time to Take Some Risk Off the Table’ on ThinkAdvisor.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.