The past year proved challenging for investors as the aging bull market for U.S. equities encountered several headwinds following a great 2017 that had been characterized by strong returns and record-low volatility. After a strong first three quarters in 2018, the S&P 500 declined 14% in the fourth quarter (at one point declining as much as 19.8% from its peak) to end the year down 4.38%. Other areas of the market fared even worse. The Russell 3000 Value declined 8.6% for the year, while international and emerging market stocks (as measured by the MSCI EAFE and MSCI EM) declined more than 13% and 14% respectively.
There have been no shortage of headlines to rattle the markets; however, despite the noise and market volatility, the recent sell off appears somewhat overdone given the prevailing strength of the U.S. economy.
The American consumer, whose spending accounts for 68% of GDP, is healthy as tax cuts boosted confidence and spending in 2018, evidenced by Mastercard (MA) reporting the strongest holiday shopping season in five years. The consumer balance sheet is strong as debt payments are at the lowest level in decades and well below pre-recession highs. The 37% decline in oil prices since September 30 is also effectively an additional tax cut for consumers as they have to pay less at the pump.
The labor market continues to be another area of strength. Unemployment is at the lowest point since 1969 and showing no signs of slowing as job growth remains steady. The tight labor market is putting upward pressure on wages which are up 3.2% year-over-year, but inflation generally remains stable.
The confidence of small business owners also bodes well for the economy. Small businesses generate nearly two-thirds of net new private-sector jobs and about half of the country’s economic output. In November, the National Federation of Independent Businesses (NFIB) reported that its Small Business Optimism Index remained near levels not achieved since 1983. The NFIB’s survey of 5,000 small business owners also indicted solid capital expenditures and plans for future capital outlays.
However, even with these positive company and economic points, we would not be surprised to see a number of companies begin to reduce earnings or revenue estimates in the near future related to a number of other areas of weakness. Growth in the housing market is slowing. Trade tensions are creating uncertainty. A stronger dollar is driving up the prices of U.S. goods internationally, hurting U.S. exports and creating a headwind for corporate profits earned overseas. Additionally, economic growth in both developed and emerging international markets is showing greater signs of slowing than in the U.S. In fact, as we were putting our finishing touches on this letter, Apple (AAPL) significantly cut their first quarter earnings guidance, citing weakness in the emerging markets and specifically China as a primary cause.
One of the biggest perceived risks for the economic expansion and the stock market is the Federal Reserve stalling growth by hiking interest rates and unwinding its balance sheet. Unlike prior tightening cycles, however, the economy is not overheating and inflation is tame, so there seems to be a greater chance that the Fed can continue to be data dependent and raise rates at a pace that doesn’t strangle the economy and put it into a recession. Currently, the U.S. economy is growing at a solid, yet unspectacular pace; and the Fed is expecting GDP growth of just 2.3% in 2019 and 1.9% thereafter. Inflation has also been running consistently at or slightly below the Fed’s target level of 2%. By raising rates now from a position of strength, the Fed hopes to not only pull off a soft landing for the economy but also to increase its ability to help lift the economy if it were to fall into a recession down the road.
More than the tightening monetary policy, the trade war seems to pose the biggest risk to the economic expansion. As it stands now, the proposed tariffs are not large enough to drastically hinder the U.S. economy. The real risk is the uncertainty created by a prolonged trade war. Uncertainty can cause business leaders to take a “wait and see” approach by putting growth projects on hold or delay the hiring of workers.
While the waning boost from the tax cuts and tighter monetary policy will slow the growth of the economy and corporate earnings, the current strength of the U.S. economy and reasonable stock valuations form a solid backdrop for the stock market going into 2019. Corporate earnings growth is expected to slow from more than 25% in 2018 to less than 10% in 2019, but the expected earnings for 2019 imply a ~14.5x forward P/E multiple on the S&P 500 Index which is below the 25-year average of 16.1x. Ultimately, a trade deal with China – which both sides have significant incentive to accomplish – and the Fed’s successful navigation of the tightening cycle would be constructive for stocks.
Sources: JP Morgan Asset Management, YCharts, NFIB Small Business Optimism Index
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International Stocks: The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.
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