Today let’s adopt a cautiously optimistic stance towards equity performance in 2019 and take a balanced look on what happened this last month and what dark clouds may loom on the horizon.
The US Equity Market
Since the beginning of 2019, up through the close on January 30th, equities have performed very strongly following one of the weakest December performances on record. The S&P 500 has recouped all 2018 calendar year declines and then some, while the larger collection of smaller companies in the Russell 2000 have made good progress on nearly recouping all of their losses. Note that we are talking about calendar year results here. The S&P 500 and Russell 2000 are still far below record highs hit during 2018.
Taking a closer look at the internals, we see that two out of the three biggest sector outperformers in 2019 are the biggest decliner from 2018 (energy), and another big decliner from 2018 (Industrials). The performance of Energy is easily attributed to changing forecasts and prices in oil (US sanctions on Venezuela, OPEC+ reducing oil production levels, etc). And Health Care has underperformed its peers in January (although still advancing) but was also the sole outperformer worth mentioning for 2018. There is therefore a continuity here that demonstrates that the December selloff was severely overdone in anticipation of negative events that never materialized. Markets therefore recovered as perceived risks subsided.
What changed
Recession fears abated. The sentiment grew that the recent equity market downturn could portend a recession in the face of what had been fast economic growth coupled with very low unemployment (granted, the steepest December declines were only seen once seasoned traders were on holiday). Also, Treasury yields had begun flashing warning signs of a potential economic slowdown ahead. Quarterly earnings growth (see below) put this fear to rest with the idea that economic growth will support earnings going forward.
Quarterly earnings were mostly good. S&P 500 fourth quarter 2018 earnings mostly beat both earnings and revenue expectations, with results from large multinationals mixed but indicating some weakness overseas. Corporate earnings and guidance are always fundamental to the performance of the stock market and, in the absence of economic data due to the US government shutdown that began on December 22 and ended on January 25th, this information became even more important to determine exactly what was happening in the US.
The Fed calmed the markets. Market participants had begun to fear that a constant rise in interest rates coupled with a constant reduction in the Fed’s balance sheet could cause potential liquidity problems. Treasury rates had also been relentlessly rising in recent months. In response, as January came around, the Fed became more communicative (the Chairman will now be speaking after every meeting) and indicated that both rate increases and the pace at which the balance sheet is reduced will be more flexible going forward (read an in-depth article on the most recent FOMC meeting by the NY Times here)
Optimism grew over US-China trade negotiations. Trade negotiations appear to be advancing well, ceteris paribus, which investors are taking as a big positive despite recent weakness in Chinese economic data. The sooner the trade war is resolved, the better for everyone involved in equities and other "risk-on" asset classes.
Clouds that could rain on the parade
This list is hardly comprehensive, but highlights a few very likely possibilities that could negatively affect US equity performance in 2019.
Political tensions remain elevated. Will the Mueller probe cause any difficulties for President Trump? Can Congress really bridge the gap between their ideological positions in the next two weeks and stave off another government shutdown (VOA covers the background to budget discussions here)? Investors typically sell on news and buy on rumor, and any potential for negative news here could lead to some stock market weakness (although, please note, it is typically prudent to take refuge in the fundamentals before making informed investment decisions).
Geopolitical tensions remain elevated. The divorce between the EU and England has become quite acrimonious (read about the most recent developments at CNN). Debt concerns over budgets passed by the Italian government continue to linger. Potential flashpoints for difficulties around Iran and North Korea remain problematic. Stability is always preferred to uncertainty.
Potential for corporate margins decline and slowing earnings growth. Strong economic growth coupled with very low unemployment typically results in upwards pressure on wages. So far, this effect has been muted, but eventually wage growth must occur. This will pressure company margins. Also, the idea of peak earnings was a hot topic widely discussed earlier this month.
Potential for global economic slowdown. The US economy is intricately connected to the global economy. The US cannot continue to climb if the rest of the world stumbles. Weak economic data out of China amid the lingering-but-paused trade war remains a concern (Marketwatch discusses how a slowdown in China could affect global economic growth).
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Cautious optimism may be the best approach for equities in 2019. Solid companies with pristine balance sheets and compelling stories have become more expensive since recent market lows, but opportunities still abound!
