Market of Extremes in 2019
By Paul Hoffmeister, Chief Economist
· We believe the equity market in 2019 will be one of extremes – where indices will be either significantly higher or lower. Less likely will be a market of middling or average returns.
· Major macro variables -- including Fed policy, the political outlook and US-China trade – remain highly ambiguous, despite some market-friendly news in each during the last month.
· These uncertainties should either resolve themselves positively and cracks in the global economy will heal (allowing for a strong market rally), or uncertainties and economic fundamentals will deteriorate significantly (and drag markets meaningfully lower).
· In our judgment, we are more likely to see in 2019 more market-positive news than negative, even though it is difficult to see the economy improving markedly from current levels.
In last month’s letter, we suggested that with the midterms completed and impeachment prospects seemingly diminished, the primary market drivers would become the Fed outlook and US-China trade negotiations. Indeed, during the last month major news emerged from both variables and moved markets in a big way.
On Wednesday, November 28, Federal Reserve Chairman Powell said that interest rates appeared to be “just below” neutral, suggesting that slightly more dovish Fed policy was likely next year.[1] That day, the comment contributed to a 2.3% rally in the S&P 500.[2]
Then on December 2, it appeared that President Trump had reached a temporary truce with China’s President Xi. Following their dinner at the G20 Summit, Trump announced that he would hold off on raising tariffs on Chinese goods to 25%.[3] In exchange, China reportedly promised to increase its purchases of US farm, energy and industrial products, and start new talks on Chinese policies related to forced technology transfers, intellectual property, cyber theft, and other perceived regulatory abuses against foreign companies.[4]
One could assume that if the White House didn’t see a significant shift in views by Chinese officials toward the US position, then this temporary agreement would not have been reached. The White House has stated, however, that if a larger agreement isn’t reached within 90 days (from December 1), then President Trump may apply the 25% tariff.[5] In trading on Monday December 3, the S&P 500 rallied 1.1%.[6]
To put last month’s trading into context, the S&P 500 rallied 2.1% the day after Election Day, 2.3% the day of Powell’s testimony, and 1.1% on the Monday following the Trump-Xi truce. These three major rallies speak to how much these macro variables have been weighing on financial markets.
So, do equity markets have the “all clear” sign?
We believe not yet, and ultimately the market in 2019 will be one of extremes – where indices will be either significantly higher or lower. Less likely will be a market of middling or average returns.
While it’s arguably positive that we’ve apparently seen (a) more political certainty following the elections, (b) a Fed that’s “listening” to market signals, and (c) positive headway in US-China negotiations, none of these variables have been completely eliminated. Major uncertainties persist and underlying cracks in the global economy are beginning to appear. China, Japan, and India are showing notable signs of weakness; and in the United States, slowing home sales and declining oil prices could portend weakening demand.[7]
In our view, these uncertainties will either resolve themselves positively and the cracks will heal (allowing for a strong market rally), or the uncertainties and economic fundamentals will deteriorate significantly (and drag markets meaningfully lower).
Some important questions for 2019 are: Will the Mueller investigation lead to the President’s impeachment and removal from office? Will the Fed simply announce an end to its rate-hiking campaign? And will China concede to the United States on some of the most intractable trade issues?
The Special Counsel investigation is a major wild card that could produce sudden, far-reaching outcomes. In a recent column for USA Today, Peter Zeidenberg, a former special prosecutor and deputy special counsel in the prosecution of Scooter Libby, suggested that the Mueller investigation appears to be reaching its endgame, and it will make the case that a conspiracy occurred to interfere with the 2016 elections “that will likely ensnare the president’s family and, quite likely, Trump himself.” [8] While Speaker Pelosi seemingly played down last month the prospect of impeachment, Democrats will very likely use their Constitutional power of executive oversight if conditions on the ground change.
As for the Fed outlook, we view Chairman Powell’s conciliatory remarks that the current funds rate is “just below” neutral as reaffirmation that forthcoming rate increases will be highly data dependent, rather than off the table. As a result, financial markets will most likely be constrained during the coming year due to concerns that good news (economically) could be used as justification for additional rate increases to temper such activity. This should also have a depressive effect on the economy. How can businesses confidently deploy risk-taking capital as the Fed seems to continuously consider “restrictive” interest rate policy?
A vague Fed policy outlook in the forthcoming year is especially probable given that some Fed officials subscribe to the Philips Curve Theory that low unemployment can spark inflation. With the official unemployment rate at 3.8% and the so-called natural rate of unemployment (known as “NAIRU”) at 4.6%, it’s hard to imagine that these FOMC members will stand by quietly while their models suggest that the historic shrinkage in excess labor threatens to cause wage-push inflation.[9] Consequently, we expect the Fed to threaten financial markets next year, at least in spirit and/or jawboning, should there be too much of an economic good thing.
A major question regarding US-China trade negotiations remains, as we outlined last month: the degree to which both sides will concede on the most sensitive trade disagreements. The 2017 US National Security Strategy Assessment concluded that China pursues six strategies of “economic aggression” with 50 acts, policies, and practices to achieve those aims.[10] Even if China acquiesced on twenty-five of those major tactics, will that be enough for President Trump? After all, any unresolved tactics will continue to be a serious thorn in the trade relationship.
Pessimists could argue that President Xi does not face as much pressure as President Trump, which could delay any meaningful resolution. Mr. Trump’s re-election is quickly approaching, and US equity market performance, a barometer that seems to be closely watched by the White House, is waning. Maybe Xi will accept short-term economic pain in China and wait for Trump to bend, or otherwise gamble to deal with a different US President in 2021?
As one might reasonably see, these three variables could easily devolve and threaten equity markets in 2019. Conversely, they could be resolved; and given the great uncertainty that exists in these variables today, it could catalyze a major relief rally.
The Mueller investigation could ultimately avoid implicating the President, forestalling an impeachment push; the Fed might “thread the needle”; and the US and China could reach at least a partial deal that’s married with a framework for future negotiations on a range of outstanding areas of disagreement.
Perhaps, amidst all the ambiguities facing the market today about a range of fundamentally important issues, the biggest question for 2019 is, which market extreme will we see?
In our judgment, we are more likely to see in 2019 more market-positive news than negative, even though it is difficult to see the economy improving markedly from current levels.
Predicting the political implications of the Mueller investigation is seemingly impossible. But, the market’s (not to mention the White House’s) protestations against the current Fed policy trajectory seem too loud and obvious to ignore. We expect Fed pronouncements to increasingly acknowledge global economic risks and the FOMC to not raise the funds rate more than a quarter point next year.
Furthermore, the pressure on Presidents Trump and Xi to reach an agreement to reduce trade tensions is, in our view, equally great. Mr. Trump is facing re-election and will be unable to easily employ other market-friendly levers to appease financial markets. As such, he appears more likely to find areas of compromise.
As for Mr. Xi, prosperity is vital for political stability in a one party system. And arguably, China has “caught up” enough, economically, with the rest of the world -- thanks in part to its protectionist trade policies. Even more, it’s unlikely that Mr. Xi would be willing to gamble on waiting for another U.S. President with whom to negotiate. Were it a Democratic-controlled White House in 2021, it’s very possible that the drive for restructuring the US-China trade relationship will be even stronger. After all, Speaker Pelosi has been a vocal critic of the relationship for a long time. For example, she unequivocally stated last year: “For years now, China’s brazenly unfair trade practices have weakened America’s economy and hurt American workers.”[11] Xi has been described by Donald Trump as a “world class poker player”; we believe he’s more likely than ever to cash in a lot of his chips while he’s ahead, rather than face even bigger risks in the coming year.[12]
Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
[1] “Did Fed’s Powell ‘Light the Fuse’ For a Year-End Stock-Market Rally?” by William Watts, November 29, 2018, MarketWatch.
[2] Ibid.
[3] “Trump’s China Trade Truce”, WSJ Editorial Board, December 2, 2018, Wall Street Journal.
[4] Ibid.
[5] “White House Corrects Top Aide on China Negotiations Timeline”, by Caroline Kelly and Kaitlan Collins, December 3, 2018, CNN.
[6] “Stocks Close Higher as S&P 500 Has Best Start to December since 2010 on Trade-War Truce”, by Sue Chang, December 3, 2018, MarketWatch.
[7] “Asia’s Weakening Economies, Record Supply Threaten to Create Oil Glut”, by Henning Gloystein, November 13, 2018, Reuters.
[8] “Mueller Is Building a Conspiracy Case That’s Likely to Ensnare Trump and His Family”, by Peter Zeidenberg, December 3, 2018, USAToday.
[9] Data source: Federal Reserve Bank of St. Louis.
[10] Full Transcript: White House National Trade Council Director Peter Navarro on Chinese Economic Aggression,” July 9, 2018, Hudson Institute.
[11] “Pelosi Statement on China Trade Investigation Memo”, Press Release, August 14, 2017, Office of Speaker-Designate Pelosi.
[12] “Trump: Xi Is a World Class Poker Player”, May 22, 2018, BBC News.