January 14 2019 Market Update

Markets are Rising: What About the Economy?

The S&P 500 Index fell 2.5% on January 3^rd before rising 3.4% on January 4^th,^[2] a continuation of the up-and-down volatility we saw around Christmas and throughout December.

There are a number of factors driving recent market movements, including trade tensions, skittishness around interest rates, and growing concerns about global economic growth. The pressure this has put on markets is significant: despite the recent rebound, as of January 4^th the S&P 500 is down over 10% from the highs reached in September.^[3]

Bond markets are also acting “weird,” to quote The Wall Street Journal.^[4]

In a nod to the possibility of a forthcoming recession, as of January 3^rd parts of the yield curve were “inverted,” meaning that some shorter-term bonds were paying out more to investors than longer-term bonds. Yield curve inversions generally precede recessions, and many analysts have voiced concerns of a slowdown over the coming two years.^[5]

The path to inversion has also been volatile: the yield on the 10-year U.S. Government bond hit a nearly one-year low of 2.55% on January 3^rd before rising to 2.71% as of January 8^th.^[6] Both the dip and market volatility have had an impact on mortgage rates, which also fell in the first week of the year.^[7]

Finally, caught in the crosshairs between a strong US dollar and a growing trade war between the US and China, emerging markets came under significant pressure in 2018. The MSCI Emerging Markets Index fell 14.58% in 2018, trailing the MSCI World Index (which tracks developed national stocks), which fell 8.71% in 2018.^[8] With some expectation of a stabilizing or falling dollar this year, the situation for emerging markets could steady, depending on how trade policy and the global economic environment evolve.^[9]  

These trends understandably have many investors concerned about what to expect as we head into 2019 and beyond.

Of course, the real answers will only come in hindsight, but there are a number of factors that we’re keeping an eye on. In this first letter of the New Year, we’ll take the opportunity to review some of the big picture issues facing global markets this year – as well as the global economy.

Global Economic Concerns

There are some concerning signals arising from economies around the world.

In November, industrial output in Germany, Europe’s largest economy, fell for the second consecutive month, alongside a decline in new manufacturing orders.^[10] German gross domestic product (or GDP, a measure of economic activity) contracted at an annualized rate of 0.8% in the third quarter – the first drop in over 3 years and the weakest performance since 2013.^[11]

Italy also saw a contraction GDP growth in the third quarter, while the European Union as a whole posted annualized GDP growth of 0.7%, the lowest growth rate since 2013.^[12] This could raise the chances of a recession in Europe.

Meanwhile, as of Tuesday, January 8, fierce negotiations over the terms of a Brexit deal in the United Kingdom continue – depending on how things develop, we could see unforeseen outcomes for both the UK and Europe.

Japan’s economic output also cooled,^[13] and manufacturing fell into contraction in China.^[14] The trade war’s effects will likely continue to be felt both in China and at home: one study found that 74% of surveyed American multinationals were being affected by the trade war; globally, 68% of surveyed multinationals operating in Asia were affected.^[15]  

All of these issues relate back to American economic activity and present potential concerns for the Federal Reserve as it guides monetary policy through 2019.

US Interest Rates and Economy

Federal Reserve Chairman Jerome Powell recently indicated that the Fed is keeping a close eye on the economy and is willing to be flexible in how it sets interest rates for the coming year.^[16] This could signal a pause if inflation remains low and markets turbulent, which could be a welcome break for borrowers and credit markets as a whole.

Overall, US economic data have remained positive. While the number of job openings fell in November to a five-month low, they still remain at record highs and continue to significantly exceed the number of unemployed Americans.^[17]

That said, there are concerns about trade and manufacturing going into 2019. With over half of our spending on imports going to inputs for American-made goods and services, continued trade tensions could start to have a more sizable impact on American companies this year. These concerns are more pressing given the rising indication that global economic growth might slow in 2019.^[18] 

More broadly, American companies are preparing for a cooler year compared to last. Across the US corporations that have issued earnings guidance for the 4^th quarter of 2018, 46% lowered their outlooks.^[19] It is easy to understand when multinationals are concerned about global economic growth, trade tensions, a strong dollar, and the potential for rising interest rates.

Should We be Worried?

Volatility might stick around for a while – or it might not: the problem with trying to engineer a forecast for the market is that it’s very easy to get it wrong. That’s why we take a bigger picture approach to the market trends, one that aligns with your bigger picture, including your risk tolerance, liquidity needs, time horizon, and overall investment policy

That said, for those who had a need to deploy cash in the past month, valuations were compelling. The forward price-to-earnings ratio for the S&P 500 – a measure of how much shares cost relative to their anticipated earnings in the future – fell to nearly the lowest level in over five years this past month and remained below the 10-year average as of January 8^th. Similarly, the Nasdaq’s price-to-earnings ratio reached a four-month low.^[20] 

We don’t know what 2019 will bring, but it does appear to be a promising year for newsworthy headlines. Between ongoing trade negotiations, the shifting balance of the economy, and the geopolitical climate around the world, we expect a steady stream of news – and possibly an ongoing environment of volatility in financial markets.

As always, we’re here to help: please reach out if you’d like to talk about your investment management strategy or portfolio, or even just to talk about the news. We’re always happy to hear from you.

Wishing you a great start to the New Year!

JSF Financial