12/24/2018
The rout in equities accelerated last week. The S&P 500 shed 7.1 percent, its worst week since August 2011. The index is now lower by 9.6 percent on the year and down 17.5 percent from its September 20 closing high, just shy of the 20 percent decline that defines a bear market, although that comes as small comfort. The Nasdaq Composite index is now in a bear market, down 21.9 percent from its August 29 high after falling 8.4 percent last week. And the small cap Russell 2000 is now down 25.8 percent after dropping 8.4 percent last week.

Most of last week’s damage came after the Federal Reserve raised the overnight interest rate for the fourth time this year. Although the increase was widely expected, investors were disappointed by the Fed’s stated intention to raise rates another two times next year. Although that was one fewer than the Fed signaled at its September meeting, investors were hoping for a signal of just one, and maybe no rate hikes next year. The fear is that the economy may already be slowing and raising rates too high would be a mistake by unnecessarily causing it to slow further.

From the Fed’s perspective, fear of a slowing economy is misplaced. Its latest forecast anticipates U.S. GDP growth of 2.3 percent in 2019. And while that is down from its 2.5 percent forecast from September, it is still a healthy, above trend rate of growth. The Fed also anticipates the unemployment rate falling to 3.5 percent, and core inflation rising to just 2.0 percent. Two additional rate hikes next year would bring the overnight rate to between 2.75-3.00 percent. In the Fed’s view, that would be in the range of what it considers neutral, where monetary policy is neither accommodative nor restrictive. A truly neutral rate, although it is impossible to discern with any real accuracy, would allow the economy to continue to expand at a sustainable pace that is non-inflationary.

Obviously, there remains a gap between where the Fed thinks the neutral rate is and where investors do. The next meeting at which another rate hike could realistically be considered is March, but investors think there is only roughly a 15 percent chance of that happening, according to the CME FedWatch tool. In fact, investors believe there is just a one-in-three chance of another rate hike at all next year.

The Trade War and Brexit Add Complexity to the Economic Situation 

Complicating the outlook for both investors and the Fed is the ongoing trade war between the U.S. and China, and its uncertain economic impact. The March 1 expiration of the so-called cease fire agreed to at the G 20 meeting in Argentina leaves little time for a meaningful agreement. If one is forthcoming, investors would certainly breathe a sigh of relief. If not, the headwind for the economy would only likely intensify, adding to the already deteriorating sentiment. The trade war is already taking its toll on the Chinese economy, prompting China to respond with fiscal stimulus.

But China is not the only source of foreign economic weakness weighing on stocks. The UK’s exit from the European Union remains as uncertain as ever, and its March 29 deadline is fast approaching. And growth is slowing in the Eurozone just as the European Central Bank prepares to end its quantitative easing program at year-end.

Concerns of Slow Growth Appear in the Bond Market; Turmoil in Washington Weighs on Markets

Fears of slowing growth have shown up in the bond market as well. The slope of the yield curve, or the difference between short-term bond yields and those on longer-term bonds has declined significantly, typically foreshadowing a period of economic weakness. Since reaching its high for the year at 3.24 percent on November 8, the yield on the ten-year U.S. Treasury note has fallen to 2.77 percent. And the yield differential with the two-year note has declined from 54 basis points at the start of the year to just 14 basis points currently. In addition, the yield differential between lower quality bonds and those of higher quality has increased as concerns over deteriorating credit quality increase.

Declining growth expectations have spilled over into lowered expectations for corporate earnings growth next year, and that is contributing to the weakness in stocks. Growth of roughly 8 percent is now expected next year, down from just over 10 percent a few weeks ago (according to FactSet). While that may not sound like much, in combination with higher interest rates and lingering questions about the economy that could result in even lower earnings growth, investors are willing to pay less for that uncertain future stream of earnings growth. Some forecasters are anticipating little or no earnings growth at all next year.

Also weighing on investor sentiment is the current turmoil in Washington. As of Friday night, nine federal departments are closed for lack of funding, due to a dispute over funding for a border wall between the U.S. and Mexico. And it appears likely that the shutdown could extend into the new year. The resignation of Defense Secretary Mattis and the advancement of his departure to January 1 has also weighed on sentiment. And the President’s apparent musings about firing Federal Reserve Chairman Powell only added to the prevailing anxiety.

We Believe the Economy Remains Sound, but Maintaining a Long-term Focus Remains Paramount

One positive result of the selloff is that the relative valuations of both stocks and lower quality bonds have become more attractive. According to Bloomberg, at the start of the year the trailing twelve-month price/earnings multiple on the S&P 500 was 21.7x. It is now 16.5x, below both the five-year average of 19.5x and the ten-year average of 17.8x. Also, at the start of the year, the yield spread between the ten-year Treasury note and the Bank of America High Yield index was 363 basis points. Today it is 522, above its five-year average of 455, although still below its ten-year average of 573 basis points.

The question for investors is whether prices have declined enough to create a buying opportunity. The answer, of course, depends in part on whether the outlook for the economy is strong enough to produce positive earnings growth. We think the answer to that question is yes. Our own forecast for 2019 is similar to the Fed’s. We anticipate growth of 2.4 percent, with only a modest increase in inflation. We believe that will be enough to produce earning growth of between 6-7 percent, and rising stock prices, with a year-end S&P 500 forecast of 2950, more than 20 percent higher than today’s level. Of course, there are certainly risks to our forecast, but we believe the economy remains fundamentally sound.

For those engaged in systematic investment strategies like dollar-cost averaging, the current selloff is an opportunity to acquire shares more cheaply, although with no assurance that they won’t get even cheaper. For those who believe it is possible to be more opportunistic by timing the market, the question of whether this is a buying opportunity is more problematic. Signs that the selling pressure has run its course are inconclusive. Volatility has spiked, but the VIX index remains below levels reached earlier this year and previously in 2015 and 2011. Trading volume last week was the highest since 2011 but remains below both 2011 and 2010 weekly highs. The Investor Intelligence Sentiment survey is at its lowest level since 2016, but only at a roughly neutral reading of bulls versus bears. The American Association of Individual Investors (AAII) sentiment survey is also currently at its most bearish since 2016.

Until markets settle down, caution remains the guiding principle. Maintaining a focus on one’s long-term investment goals is of paramount importance in the face of market turmoil like we are currently experiencing.

But to reiterate, we believe the economy remains fundamentally sound. We are not forecasting a recession next year. And we expect corporate earnings to grow and markets to recover.

Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
The NASDAQ composite index measures all NASDAQ domestic and international based common type stocks listed on the Nasdaq Stock Market.
The Russell 2000® Index is a market-capitalization-weighted index made up of the 2,000 smallest US companies in the Russell 3000.
The CME FedWatch Tool analyzes the probability of FOMC rate moves for upcoming meetings. Using 30-Day Fed Fund futures pricing data, which have long been relied upon to express the market’s views on the likelihood of changes in U.S. monetary policy, the tool visualizes both current and historical probabilities of various FOMC rate change outcomes for a given meeting date. The tool also shows the Fed’s “Dot Plot,” which reflects FOMC members’ expectations for the Fed target rate over time.
Bank of America/Merrill Lynch High Yield Master II is an index of high-yield corporate bonds which measures the broad high yield market.
Investors Intelligence is an independent provider of research and technical analysis of stocks, currencies, commodities and financial futures.
The AAII Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market short term; individuals are polled from the AAII Web site on a weekly basis.
Dollar cost averaging does not assure a profit or protect against loss.
Past performance is not a guarantee of future results.
Indexes are unmanaged and are not available for direct investment.
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