We ended 2018 facing three primary risks: trade disagreements, uncertainty related to the Federal Reserve’s plan to raise rates and deteriorating global economic numbers. The collective impact of these risks on the market – namely the fourth quarter sell-off – was certainly painting the picture for a pending recession heading into the New Year.1
However, starting with the last week of December and the first few weeks of 2019, the tables were turning. Fast forward to where we are now, and we have mostly recouped the market losses from 2018.1
In this commentary, we discuss the risks investors should be mindful of as we advance through the year, as well as some that have dissipated.
1. Trade: There is no question that the global markets and economy have felt the impact of the trade disagreements between the world’s two largest economies2 – the U.S. and China. On the U.S. side, we saw our trade deficit spike higher as companies increased their imports in an effort to beat the tariff deadline.3 Our exports to China have also dropped significantly.4 China, on the other hand, has experienced slowing growth. As a result China’s debt level has inflated to very high levels, as lending was encouraged by the Chinese government in an effort to stimulate spending.5
Now that trade discussions have seemingly improved and it looks like a deal is going to be reached in the not-too-distant future, the risk has dissipated for now and the market has reacted positively.6
2. Federal Reserve: Similar to trade, this risk has also largely been taken off the table following the Fed’s recent announcement that it will take a “patient approach” in deciding future rate hikes.7 The story we are hearing now is much different than the one the Fed was telling in 2018, where it suggested we would see additional rate hikes despite the market troubles experienced in the fourth quarter. While it seemed the Fed was going against the grain last year, the organization now appears committed to listening to the market and letting it be their guide as far as rates go, which has since resulted in additional positive market movements.
3. Slowing economic numbers: Unlike trade and the Federal Reserve, the risk of the global economic slowdown is still present and in some ways accelerating. In the U.S., gross domestic product (GDP) numbers have fallen8 and the recent jobs report was disappointing.9 Other countries around the world are also slowing. Australia, for example, has been in growth mode for nearly 29 years largely due to their exports to China, and even their economy is now teetering.10 While we’re not seeing sharp contractions, the constant drumbeat of weak performance across the globe is putting a dent in market optimism.
The good news, however, is this global economic weakness has largely been priced into markets. In fact, the market is in a much better position to deal with this weakness than it would have been in 2018 as investors now have much lower expectations. The U.S. is priced at about an 18 Price-to-Earnings (P/E) ratio, which is much lower than 2018.11 Outside the U.S. we are seeing P/E ratios fall within the 11-14 range.11 Even if we do experience a meaningful earnings contraction this year, current market valuations are not set at high expectation levels.
At Exencial, we believe the U.S. economy will slow but remain positive for the year. While the latest jobs report was not overly favorable, it did note wage growth hit a 10-year high, which is meaningful.9 Additionally, U.S. households are generally healthy. It seems consumers may have learned their lessons from The Great Recession.12 Mortgage delinquency rates, for example, are at an 18-year low.13 This strong household health gives the U.S. economy a solid foundation and puts consumers, which make up about 70 percent of the U.S. economy, in a fairly strong position.14
Sources:
1. Yahoo! Finance – S&P 500
2. Investopedia – The world’s top 20 economies
3. Trading Economics – United States balance of trade
4. Fortune – China trade war cost tops $40 billion in lost U.S. exports
5. CNBC.com – Morgan Stanley: China’s debt is set to worsen, but there’s less risk from shadow banking
6. Reuters – Deal or no deal, U.S.-China trade talks may finish in weeks: Lighthizer
7. USA Today – Federal Reserve will be ‘patient’ as it weighs rate hikes, Powell says
8. Trading Economics – United States GDP growth rate
9. USA Today – Just 20,000 jobs added in February as hiring slows, unemployment drops in latest report
10. Business Insider – Australia runs the risk of talking itself into recession
11. DFA U.S. – Equity fund characteristics as of 02/28/2019
12. Investopedia – The Great Recession
13. Yahoo! Finance – Mortgage delinquency rate hits 18-year low
14. The Balance – Consumer spending trends and current statistics
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