Author: Sean Williams | January 14, 2019
Market unrest may be here to stay in 2019
On the back of the second-longest economic expansion in U.S. history, investors received a rude awakening in 2018. Namely, they were reminded that the stock market can move down just as easily as it can go up. The 6.2% decline in the broad-based S&P 500 (INDEX: ^GSPC) was its worst performance in a decade, and it’s left a lot of investors who have the 57% peak decline of the Great Recession still fresh in their minds wondering what’ll happen next.
While no one can predict the short-term direction of market moves with any certainty, it’s almost assured challenges will arise in 2019 that could roil the broader market. What sort of events should investors be on the lookout for this year? Let’s take a closer look at seven big question marks.
1. The trade war between China and the U.S.
There’s perhaps nothing on the minds of investors in 2019 more than the potential for a trade war escalation between the two largest economies in the world by GDP, the United States and China.
Although a 90-day trade-war truce was announced at the beginning of December, there’s been nothing to indicate that the President’s Trump and Xi are any closer to reaching a long-term trade agreement. Should an agreement not be reached, it’s possible that hundreds of billions of dollars in exports for each country could face tariffs ranging between 10% and 25%. And, as a reminder, most tariffs are passed along by corporations to their consumers, resulting in higher prices for John and Jane Q. Public.
We’ve already begun to see the impact of this lingering trade war hitting brand-name companies. Back in July, all three Detroit automakers – General Motors (NYSE: GM), Ford (NYSE: F), and Fiat Chrysler Automobiles (NYSE: FCAU) -- lowered their full-year profit forecasts as a result of higher aluminum and steel prices derived from the trade war. Specifically, Ford suggested that tariffs would cost the company $1.6 billion in 2018 in North America. As the double whammy, Ford is also unable to raise the price of vehicles being hit with tariffs in China, including its premium Lincoln brand vehicles.
The longer we go without a long-term trade deal, the more unrest there’ll likely be in the market.
2. Interest rate uncertainty
Investors should also expect the Federal Reserve to be a source of confusion rather than comfort in 2019.
Even though Fed Chair Jerome Powell remarked earlier this month that the central bank would be willing to adjust its balance-sheet runoff policy if it were causing problems (the Fed is allowing $50 billion, mostly in bonds, to run off of its balance sheet each month), the Fed has been far less accommodative to a volatile market than investors would like.
Powell and the Fed Governors called for the likelihood of two quarter-point (i.e., 25 basis point) hikes to the federal funds target rate in 2019 following the December meeting. Wall Street and investors had been either looking for a holding pattern in December 2018, with two hikes in 2019, or a rate hike in December with the expectation of zero or one hike in 2019. What they got was a Fed that remains hawkish and clearly concerned about the potential for inflation.
The obvious worry is that the Federal Reserve could overshoot with its rate hikes, slowing lending activity and really putting a lid on economic growth. Since economic contractions and recessions are an inevitable part of the economic cycle, the Fed’s recently aggressive policy could be put under a microscope in 2019, leading to market volatility.
3. Yield curve flattening or inversion
Another cause for concern has been the flattening and partial inversion of the yield curve, which has been ongoing for months.
The yield curve is nothing more than a depiction of Treasury yields, expressed in a chart, over various maturities. Generally speaking, we’d like to see an upsloping chart where long-term bonds, say 10-year and 30-year, have higher yields than short-term bonds, say three-month or two-year. This type of chart is the sign of a healthy economy, and it tends to promote lending. That’s because financial institutions make their money by borrowing at short-term lending rates and lending at long-term rates. They then pocket the difference between the short- and long-term rates as net interest margin.
During most of 2018, and even the early going of 2019, the yield curve has been flattening or partially inverting. In other words, the upsloping curve has been flattening, and the gap between short-term yields and long-term yields has been shrinking significantly. At one point recently, the yield on the six-month Treasury note was higher than the five-year T-bond. As the yield curve flattens or inverts, it discourages lending, which is the fuel that lights the economic fire.
Also of note, a yield curve inversion has preceded every recession since World War II. To be clear, not all inversions have been followed by a recession, but it’s been a common warning sign that a recession may not be far off.
4. Political stalemate in Washington
Investors should also be expecting politics to play a role in 2019. Although we may not like to talk about politics, what happens on Capitol Hill from a fiscal policy perspective can and will influence the health of the economy and stock market.
On Jan. 3, 2019, the 116th United States Congress took shape, with Republicans retaining their majority control in the Senate, but ceding that majority control in the House to Democrats. Even though the stock market has historically done pretty well when Congress is divided, the division between both parties is probably going to limit any chance of major fiscal policies being passed through early 2021. This means any hope of a second tax cut or fiscal stimulus, which had been discussed by President Trump, is effectively off the table.
To add to this Washington stalemate, President Trump has been known to roil the markets by tweeting his off-the-cuff thoughts. More active on social media than any recent president, Trump has caused market meltdowns by criticizing Fed Chair Jerome Powell and commenting on the trade war. With Congress more divided than ever and Trump unapologetically outspoken, investors should ready themselves for a political whipsaw.
5. A possible GDP growth slowdown
You can rest assured that the U.S. GDP growth rate is going to be closely monitored by Wall Street and investors this year.
Although we don’t yet have data on the pivotal fourth quarter, U.S. GDP growth totaled 2.2%, 4.2%, and 3.4%, in the first, second, and third quarters of 2018, respectively. The 4.2% GDP growth rate in the second quarter was the highest level in nearly four years. But is it sustainable? The answer is probably no.
You see, the Tax Cuts and Jobs Act that was signed into law by President Trump in December 2017 completely overhauled the U.S. tax code for the first time in more than three decades. It permanently reduced the peak marginal corporate income tax rate to 21% from 35%, and lowered the tax liability for most American taxpayers, with a sunset of Dec. 31, 2025 for these individual tax cuts. It’s possible that putting extra cash into the pockets of taxpayers in a consumption-driven economy, as well as boosting corporate profitability by lowering the income tax rate, is responsible for this boost in GDP growth.
But if that’s the case, the initial boost of added disposable income could be short-lived for both corporations and individual taxpayers. If U.S. GDP were to fall below 2% on a quarterly basis, it’s likely that investors wouldn’t be happy.
6. A housing market slump
Just as the housing bubble proved to be a major warning sign prior to the Great Recession, worrisome data is once again emerging in the housing industry that could cause concern among investors.
For starters, 30-year mortgage rates have been heading higher since the midpoint of 2016. They’ve risen from around 3.5% to between 4.5% and 5% in recent months. Although a 30-year mortgage rate of 5% is still very low on an historical basis, the spoiled American homebuyer was given more than a half-decade of record-low rates thank to a dovish Federal Reserve. Now that mortgage rates have begun to normalize a bit, mortgage applications have stopped rising as prospective homebuyers are unwilling to accept higher mortgage rates.
We’re also beginning to see some disturbing data from California. Often viewed as a leading indicator of housing health, existing home and condominium sales in California dove 18% in September. Furthermore, new home sales came in 47% below their September average, dating back 30 years. All signs are pointing to a possible peak or contraction in housing, which could be bad news for the stock market.
7. To Brexit, or not to Brexit
Last, but certainly not least, a lot of eyes are likely to be on Britain in 2019 as the country deals with the ramifications of a 2016 vote by its residents to leave the European Union.
Known as “Brexit” (short for “British exit”), Britain’s attempts to form trade deals with other EU nations haven’t exactly gone as planned. In fact, Prime Minister Theresa May, who is responsible for spearheading Britain’s EU exit and working out foreign trade agreements, has lacked for support within her own party. Although a vote for May’s Brexit deal is scheduled for tomorrow, Jan. 15, there are little assurances it’ll pass, even with other EU leaders already agreeing to the deal.
Regardless of what the members of Parliament decide tomorrow, Britain will leave the EU, effective Mar. 29, 2019. If no deal is in place, Britain runs the genuine risk of entering a recession and bringing the rest of the developed world down with it. Expect the market to be especially jittery if no deal is reached.
The only number you’ll want to keep in mind in 2019
Based on this list of events and potential adverse outcomes, it’s pretty clear that the stock market is facing one of its most challenging years in some time. But there’s also something that investors will want to keep in mind. One number in particular that’ll help them look past the near-term white noise and focus on the long-term: That number is 100%.
Since 1950, the broad-based S&P 500 has undergone 37 corrections (i.e., a decline of at least 10% from a recent high), including the current correction. Each and every one of the previous 36 corrections has eventually been erased by a bull market rally. That’s 36-for-36 -- a 100% success rate.
Put it another context, this data suggests that if you buy high-quality companies during stock market corrections and allow the variable of time to work in your favor, you should, ultimately, come out a winner. Regardless of what 2019 has in store for the stock market, bargains abound that in five, 10, or 25 years could return many times over for opportunistic investors.
In sum, don’t let short-term pain impact your long-term gain.