• Equities continue to face worries around trade, data, and levels of corporate debt.
• Positive market fundamentals remain intact.
U.S. equities have started last week on a sour note. There is a laundry list of concerns worrying investors including the U.S.-China trade spat, a possible recession, the Fed’s plans to raise interest rates, the shape of the yield curve, and corporate debt. When you take a step back and review key fundamentals, without these overhangs, the equity markets should be taking a different path. While some caution is appropriate in times like this as investor pessimism has clearly increased, we continue to point to strong fundamentals and remain cautiously optimistic about market returns for the balance of this year and early 2019.
Last Monday's trading sent U.S. equities lower with the most major indices down nearly 2% at one point. While investors could point to many concerns, they cited the following as primary reasons to sell. First, there continues to be conflicting information around the tariff negotiations between Washington and Beijing. This has raised investor uneasiness as tariffs and trade wars have historically been detrimental to global economies and, in some cases, recessionary. Second, on Friday we saw a weaker than expected employment report. Though the report showed the economy created 155,000 new jobs in November, because it missed expectations, some investors believe this is a possible canary in the coal mine that the trade war could be moving the U.S. economy to a recession. Third, investors have been growing alarmed at the record amount of corporate debt.
These issues worrying investors are real and could continue to have further market ramifications. However, let us step back and look at key market fundamentals.
First, the U.S.-China trade war is the biggest concern facing investors as it essentially adds a sales tax on purchases. Both countries realize the gravity of the situation and we are optimistic a resolution will be found. From the U.S. side, using the newly signed United States-Mexico-Canada Agreement (also known as NAFTA 2.0) as an indication, despite President Trump calling NAFTA the “worst trade deal ever,” it is fairly similar to the new agreement. Mexico and Canada made only minor concessions and the U.S. signed the trade deal. Likewise, we expect China will make some concessions and a trade deal compromise will be eventually reached. In our opinion, weaker readings on Chinese economic data and a decline in the Chinese stock market are pressuring Chinese leaders to negotiate.
Second, looking at U.S. economic data, despite the weaker November employment report we are on a solid footing. Looking at the labor market, the unemployment rate is a very
Third, while some investors have raised alarms about the record amount of corporate debt, we are less concerned. Yes, we are uneasy about the high yield and floating rate debt parts of the bond market given they are expensive. However, we are not as concerned as others about the overall amount of corporate debt. Just like most Americans are refinancing their mortgages, companies took advantage of the
These aforementioned concerns are causing investor uneasiness and we are watching them very closely. However, our cautious optimism is not a symptom of ignorant bliss. Think about this. In 2018, the U.S. economy should grow close to 3%, corporate earnings should rise about 20%, individuals and corporations have lower taxes, the unemployment rate is near 50-year lows, and energy prices, which have a positive impact on consumer spending, are down double digits. At the same time, U.S. equities are negative for the year.
Of course, the financial markets are pricing in future expectations including the possibility of a recession next year. This is quite evident given what we have seen in the bond market and the worry around a flat yield curve. We, on the other hand, do not see a recession next year. The U.S. economy is likely to slow as rising input costs such as wage growth and higher interest rates impact domestic growth. However, a two-quarter decline in domestic economic output, the classic definition of a recession, is not likely to happen in 2019, though 2020 is up in the air. The economy is too strong on many facets and, despite some criticism, the Federal Reserve is doing a great job gradually raising interest rates and then gauging the economic impact. In the past, the Fed has not been gradual or very communicative in their prognosis. With the Fed likely to raise rates later this month, they may signal a less restrictive policy next year and, in fact, some believe that after this next rate hike, they are done raising interest rates.
Although we do not possess a crystal ball as to when markets will resume their ascent, we do note some recent positives including the recent outperformance of emerging market stocks and other aggressive areas of the financial markets. Furthermore, the sizeable drop in interest rates, especially the 10-Year U.S.
With that in mind, stay tuned for "Part 2" and our suggestions for best positioning yourself for a major downturn whether it happens or not.
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