Market Updates

March 9, 2019 marked the ten-year anniversary of the equity bull market. The climb has been challenging, with bouts of episodic volatility littered throughout, but ultimately investors have been treated to ten years of impressive gains. This bull market has demonstrated that global economic momentum ebbs and flows with trends in manufacturing and trade, leading to market corrections as valuations reset to reflect increased uncertainty about the future.

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2019 is shaping up to be a mirror image of 2018, which began with widespread euphoria about a continuing synchronized global expansion. By the spring, however, aggressive Federal Reserve (Fed) rate-hike plans and trade-war concerns had sparked a global slowdown. In sharp contrast, this year has begun with widespread expectations of continued global slowing. Instead, with the Fed and trade concerns now becoming tailwinds, in our view, the global economy is on the cusp of a new upcycle, which should become apparent, likely by the second half.

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Although U.S. real GDP growth surprised the consensus to the upside in the fourth-quarter of 2018, economic data for December and January have come in on the weak side, consistent with excessive restraint from Fed rate hikes and the shock to confidence they imparted by the end of 2018. Still, there are reasons to remain optimistic about a continuation of the expansion this year and next. The sharp December decline in consumer spending followed two very strong months, and a sustained deterioration would be inconsistent with solid real-wage growth. Encouragingly, consumer expectations as measured by The Conference Board rose sharply in February following the Fed’s early-year U-turn on policy and the end of the government shutdown.

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The surge in equity prices so far in 2019 dates back to the January 4 about-face by Fed Chairman Powell, where he reversed his hawkish stance communicated after hiking rates at the December 18–19 Federal Open Market Committee (FOMC) meeting. At that time, the Fed chair was still signaling more rate hikes for 2019 and sustained Quantitative Easing (QT) on automatic pilot. Just two weeks later, a new dovish message was apparent.

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Fears of government deficits and debt have been a ubiquitous feature of the American political discourse since the days of the founding fathers. Indeed, the idea of a perpetual centralgovernment debt was a significant bone of contention between Alexander Hamilton and Thomas Jefferson that contributed to the creation of political parties and the bipartisan nature of the U.S. political system. Chronicles of the debates in the early days of the republic make it clear that the bitter animosities of today’s political scene are nothing new.

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The FOMC has acknowledged the need for a pause in its tightening campaign given waning momentum in U.S. and global growth and inflation indicators, high financial-market volatility and elevated economic policy uncertainty. The restraining effect of its cumulative rate hikes to date has become increasingly clear and is likely to continue to reverberate throughout the U.S. and global economy, as is typical following a sharp flattening of the yield curve.

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Following a sanguine 2017, concerns last year ranging from Federal Reserve (Fed) actions to trade disputes, to slowing growth and geopolitical tensions contributed to higher volatility across financial markets. We believe 2019 should see no shortage of market-moving events either, amid U.S.-China trade negotiations, Fed meetings, debt ceiling debates, and deliberations over Brexit. In this week's Capital Market Outlook, we outline a few catalysts for investors to monitor in upcoming months.

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Global risk assets are pushing forward despite persistent policy-related stresses that appear to be gaining momentum. The list of stressors is not short: The U.S.-China trade war, Brexit, talks of a looming fiscal hangover, the government shutdown and tighter U.S. monetary policy are probably cited most often as risks to the outlook for the global economy and risk assets. Climate change/global warming is also a frequent contender. It is not surprising then that global economic policy uncertainty reached an all-time high in December.

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Weakening leading indicators of global growth combined with softer-than-expected incoming data from Europe and China and aggressive Fed tightening have created an explosive mix that culminated at the turn of the year with a surge in risk aversion and financial-market turmoil. Indeed, a hawkish Fed policy and rhetoric increasingly out of sync with the economic outlook predictably spurred a frantic market rush to translate shattered expectations of prudent Fed policy into growing expectations of recession by the end of 2019.

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Monetary policy mistakes are inevitable. The economic theory behind policy is far from perfect and often difficult to implement. As a result, tightening and easing cycles tend to go too far relative to policy objectives until it becomes apparent that enough is enough. At his appearance before the American Economic Association conference in Atlanta on January 4, Fed Chairman Powell essentially admitted that the Fed had reached such a point in its latest tightening cycle. This sparked a major risk-on rally in markets, typical of the end of bear markets when Fed policy finally stops tightening.

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As we look to 2019, the key risks we are monitoring continue to be a trade war between the U.S. and China, a rapid deceleration in U.S. and global growth and an overly aggressive Federal Reserve (Fed). But as we look below the surface, we also see a number of “tail risks” out there: low-probability but high-impact events that could be detrimental to the economic cycle. We emphasize that these are unlikely to materialize to create broad contagion for the economy and markets in 2019. Our view remains for above-trend gross domestic product (GDP) growth in the U.S. and modest equity returns, and we maintain our slightly pro-risk bias in portfolios.

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It is well understood that sound financial markets are an important driver of economic growth and welfare. They enable corporations to raise capital, access a wide investor base and fund growth projects, thus contributing to innovation in the economy. They provide investment opportunities for families, both directly and through funds, 401(k)s, and pensions. Investors and savers alike can access more attractive investments from a return perspective than what can be achieved via traditional banking products like deposits. In addition, these holdings have the potential to diversify portfolios and help manage risks.

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Clearly, the market was expecting the Federal Reserve’s comments to be more accommodative for 2019. Investors are not necessarily looking for fewer than two hikes next year; but rather they are looking for the Fed’s commentary to indicate an understanding that financial conditions are tighter than they realize. In addition, weakness overseas and inflation that has ticked below their own target rate, do not seem to be factored into their commentary about future policy in any meaningful way.

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As we move into the last two weeks of trade for 2018 and are just a few days away from the last Federal Open Market Committee (FOMC) meeting for the year, equity markets remain weak. Despite still-positive economic news in the U.S., the overseas environment continues to struggle, particularly in Europe and China.

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Over the past decade, the Fed has moved toward a formal commitment to keeping inflation around a 2% target. In October 2014, there was an agreement to make it clear that “its inflation objective is symmetric.” This was expressed in the phrase that the “Committee would be concerned if inflation were running persistently above or below” its 2% objective. Since 2012, the Committee has reaffirmed this inflation objective with “appropriate revisions” at its annual organizational meetings in January. The 2% inflation objective is based on an empirical determination that it represents a reasonable anchor for inflation expectations to provide the best long-run performance for the U.S. economy.

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Our view of a “Goldilocks” economy this year, characterized by strengthening but not overheating growth and inflation, has been validated. As past correlations indicated, surging consumer and business sentiment to almost 20-year highs were followed by a meaningful acceleration in real gross domestic product (GDP) growth to just above 3%, led by sizzling real consumer-spending growth averaging around 4% in the summer and fall. While housing has suffered stronger-than-expected headwinds from rising interest rates, real business investment growth accelerated to an average of around 7%, helped by surging revenues and earnings as well as favorable lending conditions.

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The global economy entered 2018 with a full head of steam in a synchronized global expansion that almost immediately began to succumb to the forces of rising inflation and oil prices along with the impact of persistent U.S. monetary policy tightening. Countries and sectors that had taken advantage of zero interest rates on dollar loans to leverage balance sheets began to feel the impact of higher rates. By the spring, it became apparent that a strong U.S. economy buoyed by tax reform, deregulation and fiscal stimulus was accelerating, while the European economy and some emerging markets started to slow down.

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As we gear up for the holiday season, corporate earnings were once again considered the gift that kept on giving, gauged by Q3 S&P 500 EPS growth tracking 27% YoY. The results are more impressive as we unwrap their contents further, currently illustrating solid revenue gains, cost containment and sustainability. Forward guidance has also been firm with company management commentary generally reinforcing positive momentum moving forward. We expect earnings to continue their ascent through future quarters.

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October employment data show no signs of the slowdown markets continue to fear. Despite trade tensions, Fed rate hikes and the political uncertainty surrounding the mid-term elections, the U.S. economy continues to the upside. Payroll employment, household survey employment and the ADP survey measure of private job creation all rose by over 200,000 in October, surpassing economists’ forecasts by a wide margin.

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Rapid industrialization of major Emerging Market economies, a whirlwind of technological advancements in telecommunications, information technology, transportation and logistics—along with the search for low costs of production, have resulted in dizzying economic integration in recent decades. Yet, signs that globalization has occurred too fast and at greater costs than promised have accumulated.

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"When it comes to active and passive investment approaches, there are no absolute rules of thumb and it need not be a binary decision in favor of one approach over the other. Instead, we believe a thoughtfully constructed mix of both active and passive strategies in varying amounts can potentially help investors achieve their goals."

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This month equity markets experienced a sharp sell-off, as concern over recently higher rates and decelerating earnings led to a rotation out of high-growth/momentum equities into more defensive, value-oriented segments of the market. We believe fears that the cycle is ending are premature, and that rising interest rates reflect a shift into an environment of stronger growth and higher interest rates along with higher volatility, with meaningful implications for portfolio positioning.

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Despite extremely high business and consumer confidence, markets and the financial media continue to build a wall of worry citing a litany of reasons why the U.S. economic boom is currently living on borrowed time. These include trade worries, a rising fiscal deficit, peak earnings worries, rising interest rates, a shortage of labor, peak auto and housing cycles and the presumed-temporary “sugar high” from late-cycle fiscal stimulus.

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Early this year, we identified the monetary tightening cycle and the return of inflation to the Fed’s target level as key reasons to expect equity market volatility to return to more normal levels. The yield curve, which is a good indicator of monetary policy tightness or ease, tends to lead the Volatility Index by about two years. Currently, it suggests that volatility should fundamentally trend up and average more historically normal levels by late 2020.

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US. stocks are down about 5 percent from their September all-time highs, with NASDAQ and Technology as one of the worst performers. The sell-off is driven by a sharp rotation, from high growth, high momentum, highly valued segments of the equity market to cash, short-selling fixed income and some parts of the defensive sectors. Of course, market sell-offs are not abnormal. Typical years have multiple drawdowns of 5 percent or more. We view this as a healthy correction driven by technical factors not fundmental.

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Our early-year expectations of a likely peak in global manufacturing and trade growth appear to be validated by recent data. The slowdown in growth momentum has been mild, however, as our expectations for upside risks to both U.S. sentiment and "hard" data have also materialized, helping support both global purchasing managers’ surveys and actual activity.

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While the U.S. equity market has generally outperformed the rest of the world (ROW) since the 2008 financial crisis, it has surprised investors even more in 2018. Coming into the year, there was a general expectation that the synchronized global expansion that began in 2016 would continue. Under this assumption, most strategists expected markets outside the U.S. to continue their catch-up after a decade of underperformance.

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1. Europe faces a number of headwinds.
2. Upside risk to oil prices heading into 2019.
3. Trade wars and emerging markets. Catalysts for a reversal in either?
4. Stay the course on defense stocks as a long-term growth industry.

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While the U.S. equity market has generally outperformed the rest of the world (ROW) since the 2008 financial crisis, it has surprised investors even more in 2018. Coming into the year, there was a general expectation that the synchronized global expansion that began in 2016 would continue. Under this assumption, most strategists expected markets outside the U.S. to continue their catch-up after a decade of underperformance.

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Beauty is in the eye of the beholder. Similarly, judgments about monetary policy tend to vary with the views of the observer. Fed Chairman Powell’s comments at the Jackson Hole Symposium on August 24 are a good example.

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From strong consumer spending, a robust labor market, and accelerating business investment to surging corporate revenues and profits, elevated business and consumer confidence, normalizing inflation, and still accommodative Fed monetary policy, our view of "goldilocks" U.S. economic conditions and expectations for a prolonged economic expansion have continued to be validated. We expect sustained strength in business investment and consumer spending as well as employment growth as the year progresses, with real gross domestic product (GDP) growth likely continuing to surprise to the upside as its trend strengthens. At the same time, we maintain the view that growth is unlikely to overheat, causing the Fed to pause sooner than is generally expected.

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While the pundits obsess over the supposed negative consequences of a trade war, business and consumer confidence show few signs of any impact. Quite the contrary. In its August report on small business confidence, the National Federation of Independent Business (NFIB) noted that “small business owners have never been so optimistic for so long. And despite challenges in finding qualified workers to fill a record number of job openings, they’re taking advantage of this economy and pursuing growth.”

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Given the normalization of Treasury yields, YTD performance of the preferred market has waned following a very strong 2017. That said, preferred valuations have held up well relative to investment grade corporates (IG). Despite the higher interest rate environment, YTD total return through July 10 on the ICE BofAML Fixed Rate Preferred Securities Index was roughly 0.8% compared to -2.6% for the Bloomberg Barclays Investment Grade Corporate index. The yield-to-worst (YTW) for the broader $25 par market has moved off near multi-year lows, reached during the first quarter, and is now generally at a multiyear high of approximately 5%, depending on the individual issuer and security structural characteristics.

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While lower-for-longer interest rates and a flatter yield curve garner most of the attention, the macro factors that matter the most for U.S. financials, particularly banks, continue their solid track: Consumer spending growth is steady, home prices are growing at a mid-single-digit pace, and valuations are attractive both on a relative and absolute basis. Balance sheets for both banks and consumers are in good shape. Additionally, the headwinds from financial regulation are fading.

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One thing is clear halfway through calendar-year 2018. The pundits seriously underestimated the positive effects of fiscal reform on the U.S. economy. The latest consensus forecasts in the Blue Chip Economic Indicators tell the story. Once again, surveyed economists raised their forecast for 2018 investment spending growth from 6.2% in May to 6.5% in June. A year ago, the consensus only saw 3.7% growth in investment for 2018.

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Signs that peak earnings momentum was hit early in the year have turned investors more cautious and left the U.S. equity market range-bound in the first half of 2018. In many respects, the U.S. economy entered 2018 with a second wind as many indicators surged in a way usually only seen in the immediate aftermath of a recession, when expansions are just beginning.

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The June 13 Federal Open Market Committee (FOMC) meeting was generally judged to result in a slightly hawkish outcome. For example, the Financial Times declared “Hawkish Fed lifts rates as Trump tax cuts fuel economic expansion.” There were slight upticks in the Fed’s outlook for gross domestic product (GDP) growth, inflation and the Fed funds rate for the next two years as well as a downward revision to the expected unemployment rate.

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In spite of perceived undervaluation and early cycle growth potential versus the U.S., and contrary to consensus expectations, emerging market (EM) and Eurozone equities have underperformed relative to the U.S. this year. Broadbased dollar exchange-rate strength has also defied consensus expectations for continued dollar depreciation in 2018, predicated on growing trade deficits and an increased U.S. government debt burden.

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U.S. economic data over the past month have confirmed our expectations for strong growth with contained inflation. From employment to wage growth, and from manufacturing surveys to business investment and consumer confidence, U.S. economic data are consistent with a sharp reacceleration from the 2.2% annualized growth pace in the first quarter to over 4% in the second quarter according to recent estimates from the Atlanta Fed and others.

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The major leading indicators of global capital spending prospects that we track have been in an upswing since the end of 2016 (Exhibit 1). In the U.S., the capital expenditure (CAPEX) cycle is experiencing a relatively stronger resurgence than the rest of the world as a result of the fiscal stimulus boost, which added to tailwinds from stronger global growth, lower economic policy uncertainty, rising commodity prices and declining slack in capacity utilization.

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After several years during which the Fed and the markets have been at odds—the Fed predicting inflation’s return and higher rates, the market is more circumspect and ultimately being proven right—both are now finally on the same page. The market started to capitulate in September 2017; strong employment and a growing belief that fiscal and tax reforms would pass forced the market to acknowledge the likelihood of higher inflation and a more resolute Fed.

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The tug of war between fears of accelerating inflation and rising interest rates versus worries of an upcoming economicgrowth slowdown in light of mixed global-economic data surprises in recent months has raised doubt about the endurance of the U.S. bull market in stocks. While a pause in the decade-old bull market is not surprising after the eyepopping 25% S&P 500 price rally between January 2017 and January 2018, we believe that worries about growth, inflation and interest rates are exaggerated.

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Organization of the Petroleum Exporting Countries (OPEC) supply restraint in the face of strong global oil demand has been the main cause behind a 30%-plus gain in Brent oil prices since late 2017. Declining global oil inventories combined with market-access constraints on rising Canadian oil supply and bottlenecks in the distribution of surging Permian Basin shale-oil flows have increased supply concerns.

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In May, the current economic expansion will be the second longest in U.S. history, surpassing the 1960s expansion, which lasted 106 months according to the official cycle-dating committee of the National Bureau of Economic Research. For years, we have been forecasting that the expansion would continue through the summer of 2019, making it the longest ever by surpassing the 1990s expansion, which was 120 months long.

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“Hard” economic data have continued to track the signals from “soft” data, such as business and consumer surveys, whose strength over the past year-and-a-half portended renewed vigor in U.S. and global growth. The final read for the fourthquarter real Gross Domestic Product (GDP) growth was revised from 2.5% to 2.9%, just shy of our expectations for a third “Hard” economic data have continued to track the signals from “soft” data, such as business and consumer surveys, whose strength over the past year-and-a-half portended renewed vigor in U.S. and global growth. The final read for the fourthquarter real Gross Domestic Product (GDP) growth was revised from 2.5% to 2.9%, just shy of our expectations for a third consecutive quarter of 3% growth.

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Since the start of the year, we have seen a number of headlines that have prompted a spike in equity market volatility and resulted in steep market sell-offs, resulting in the S&P 500’s first negative quarter since 2015. Among these are announcements from the Trump administration on plans for steel and aluminum tariffs, as well as tariffs on Chinese imports, and an increased level of regulatory scrutiny on major technology companies. These events represent idiosyncratic market risks that have pushed equity market volatility to multi-year highs to start 2018.

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This year U.S. dollar (USD) LIBOR—the London Interbank Offered Rate, an estimate of USD borrowing costs for a top-tier bank—has risen steadily and sharply. As of March 23, three-month USD LIBOR was 2.29% – 0.60% higher than year-end, and its highest level since 2008. LIBOR is one of the world’s most important short-term interest rates, serving as the reference rate for trillions of dollars worth of financial instruments.

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As we discussed in last week’s report, there are similarities between the current cycle and the 1950s and 1980s expansions, as well as differences that give the current cycle distinct features. One important characteristic of the current expansion is that it followed the most severe financial crisis since the 1930s. The unwinding of excesses in household mortgage-debt-related sectors, housing and banking, hampered the typical early-cycle recovery of these sectors, restraining the expansion in the process, similar to what happened in the 1990s expansion. A number of other aspects of the 1990s expansion offer additional insights into how the current expansion is unfolding.

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The reality of the strongest global economic growth in six years, surging U.S. corporate profits, strong consumer sentiment, robust business confidence and stimulative fiscal policy measures has finally dawned on markets, causing volatile moves in interest rates and equity prices. As discussed in past reports, the strengthening growth and inflation environment has been in the making for more than a year, as clearly reflected in the strong upside momentum in various leading indicators of activity and price trends. Although economic data have become somewhat more mixed this year, as reflected in the rollover in the Citi Economic Surprise index both in the U.S. and globally since January, leading indicators remain consistent with a strong U.S. economic growth outlook enhanced by recently enacted fiscal stimulus from tax cuts and a two-year budget deal that is designed to increase government spending.

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