Stay Invested, Be Vigilant
2018 was a year of divergence. Economic and business performance were robust. Global growth was above trend and the U.S. economy outperformed. Earnings growth, boosted by tax reform, was high. Fiscal stimulus in the U.S. supported strong consumer and business activity.
But these solid economic fundamentals were met with poor market performance, particularly in the fourth quarter.
What Happened Last Year?
The elephant in the room is volatility. Volatility did increase from cyclical lows in 2017 to a “standard” level of volatility in 2018. However, the real surprise was not volatility itself but the climactic, liquidity-driven drawdown into December.
S&P 500 Price Action
Sources: New York Life Investments; Bloomberg; S&P; data as of 12/18/2018
If economic growth is so robust, why are we seeing this level of drawdown? To begin, earnings and economic growth are indeed growing, but they have likely peaked. In this environment, investors tend to be skittish and overreact to news headlines and data releases.
The dynamic is exacerbated by the build-up of geopolitical risk and political uncertainty, making it difficult for businesses and investors to make concrete plans.
Finally, with the highly anticipated unwind of quantitative easing in the U.S., liquidity is becoming an issue. The Fed has become a net seller of securities, without any natural buyers. Add it all together and you have a negative market dynamic despite strong economic fundamentals.
Looking Ahead: Bases Are Loaded
With all the pessimism, it is important for investors to note that volatility goes both ways. With drawdowns at the end of 2018, we see less likelihood of heavy downside volatility, and opportunity for capturing upside.
Four factors contribute to potential upside this year. In an optimistic scenario, these four factors could have loaded the bases for a market grand slam.
First base: Real interest rates are near zero.
Second base: Sentiment is protracted, meaning a lot of cash is on hand. The American Association of Individual Investors found that 50% of investors are bearish, the most since 2013.
Third base: Valuations are low. Forward price/earnings ratios on the S&P 500 are low relative to their historical averages, and global markets are even cheaper. Unless we expected recession – which we don’t – this indicates room for multiple expansion.
Grand Slam: The Federal Reserve is moving towards a more dovish posture, removing one of the key risks that weighed on sentiment in 2018. As investor fears on this and some key geopolitical risks alleviate, we could be looking at a double-digit market return for U.S. equity this year.
Financial Markets in 2019
The prolonged bull market may have paused to rest, but it is far from exhausted. Both fundamentals and valuations provide a good backdrop for risk assets in 2019.
Stay invested. The economic expansion remains on track. After significant drawdowns in 2018 we believe that there are opportunities across asset classes, and we are working with our investors to identify good positioning and solutions. In our portfolios, we prefer equities, with a few careful plays in fixed income. The idea is to maintain the risk-on stance of our portfolios but consider diversification and resilience in this late-cycle environment.
Looking for More Market Insights?Download Our Full 2019 Economic Outlook
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