January Market Commentary
By Paul Hoffmeister, Chief Economist
January 3, 2019
· The primary macrovariables driving equities in 2018 appeared to be the Fed and US-China trade. Positive news in both during 2019 are likely to spark a strong rally.
· Market volatility and seemingly abrupt weakness in US manufacturing will likely cause the Fed to raise the funds rate once this year, if at all. Meanwhile, political and economic pressure should cause President Trump and Xi to reach a partial trade deal.
· During Q4 2018, the S&P 500 Index declined 14.0% (not including dividends). Prior to the last quarter, the S&P 500 has experienced 16 quarters since 1970 in which the index has declined 10% or more. The average return in the S&P 500 four quarters later was 16.1% (not including dividends). In only four instances did the S&P 500 suffer a negative return 4 quarters later.
· For us to become worried about an approaching recession, we need to see US manufacturing and employment conditions worsen significantly more.
· A “Trump impeachment + removal from office” scenario is a seemingly impossible variable to forecast, but needs to be considered when thinking about the behavior of financial markets during the coming year. Based on the 1998 Clinton impeachment events, as discussed in previous client letters, we estimate that this would lead to a 15% decline in equities.
· Our base case scenario estimates a 15% return for the S&P 500 in 2019 -- but with intermittent volatility, notably in response to political uncertainty -- and a year-end 10-year Treasury yield of 3%. Our favorite asset classes this year are emerging markets and oil, which we expect to experience major relief from last year’s stresses.
When we look back at the ups and downs of the stock market in 2018, three things are apparent to us: 1) the two primary macrovariables moving equities last year were the Fed and US-China trade; 2) nervousness about aggressive Fed policy led to the two major market selloffs (in February, and then between October and December); and 3) positive and negative news in US-China trade negotiations led to a lot of the intervening market volatility.
As 2018 closes, we believe that market participants have heavily discounted for excessively aggressive Fed policy in 2019 and, at best, a 50/50 probability of Presidents Trump and Xi reaching a trade deal. This suggests that positive news from both variables – such as no rate increases in 2019 and at least a partial US-China trade deal – will ignite stocks.
As we assess the monetary and trade variables today, we’re seeing encouraging signs, leading us to believe that the worst is over for equities during the near-term and that 2019 will see a strong rally.
First, Fed officials appear to have been caught off guard and worried about the significant stock market weakness following the December 19 FOMC meeting where the Committee telegraphed a policy trajectory wildly out of line with market expectations. The Committee collectively expected two more quarter point rate increases in 2019, whereas the futures market is currently expecting not even a single rate hike. The ensuing stock market selloff appeared to have led New York Fed President John Williams to go on CNBC on December 21 in order to soothe markets. He indicated that Fed rate forecasts in 2019 were not promises, and the Fed will adjust if necessary. Willliams said, “We’re going to go into the new year with eyes wide open, willing to read the data, listen to what we’re hearing, reassess our economic outlook and take the right policy decisions that will keep this economy strong.”
More importantly, though, economic data is beginning to show a dramatic slowdown that will demand the Fed to be cautious this year. During the last month, manufacturing surveys from the New York, Philadelphia, Richmond, and Dallas Federal Reserve Banks were all worrisome.
The Richmond Fed’s manufacturing survey in December showed the largest month-over-month decline in activity in its history. At the same time, the Dallas Fed’s survey showed the largest month-over-month decline since the 2008-2009 financial crisis. If the FOMC is truly data dependent and not on a preset policy course, then the recent economic data – within the context of today’s low inflation environment -- should give the FOMC sufficient reason to pause its current rate-hiking cycle.
The manufacturing surveys of the last month are showing, in our view, that the slowing housing market and declining oil prices are creating stresses in key segments of the economy. Furthermore, and perhaps more importantly, the specter of aggressive Fed policy that seeks to limit growth, which has been omnipresent since February and especially pronounced since October, is arguably restraining economic activity and risk-taking more than many appreciate.
In sum, as we assess the weakening economic data and the apparent concern on John Williams’ part over the recent market panic, we expect Fed policy to shift decisively dovish in 2019. And if monetary policy is the most important macrovariable today, as it seemed to be in 2018, then it should hold that the indications of such a shift will spark a strong equity market recovery.
There are also encouraging signs in the US-China trade variable. On December 29, President Trump announced via Twitter that he had a “long and very good call” with President Xi, and that a “deal is moving along very well!” We continue to be more optimistic than many that at least a partial trade deal will be reached, as the pressure seems to be severe on both leaders to strike a deal.
According to the Chinese National Bureau of Statistics, manufacturing activity in China contracted in December, for the first time in more than two years. Even more, the Shanghai Composite was one of the weakest stock markets in the world in 2018, down nearly 25%, according to Dow Jones.
At the same time, President Trump, who will begin campaigning for re-election later this year, will not have many big levers left to strengthen the economy. More tax cuts are unlikely this year, leaving him with deregulation and trade agreements. For a President who focused his economic platform so much on revitalizing the Rust Belt through major trade reforms -- and thereby winning Pennsylvania, Ohio and Michigan in 2016 – a US-China breakthrough on trade is almost vital for his re-election.
It also seems to us that Xi would rather negotiate with Mr. Trump now, than risk the possibility of negotiating with a Democratic president in 2021. Democrats seem to already be in close alignment with the President on trade. In May, Senate Minority Leader Chuck Schumer said, “As I’ve always said, when it comes to being tough on China’s trading practices, I’m closer to Trump than Obama or Bush.” But aside from trade, many Democrats have been much more critical than Trump on alleged Chinese human rights violations. Incoming House Speaker Pelosi has been a famously vocal human rights critic of China. For as tough as Trump has appeared to be on China in recent years, he may be the easiest person for Xi to negotiate with in the current political environment.
In addition to our assessment and predictions for Fed and US-China trade policy in 2019, the history of the modern stock market also suggests a strong probability of an equity rebound this year.
During Q4 2018, the S&P 500 Index declined 14.0% (not including dividends). Prior to the last quarter, the S&P 500 has experienced 16 quarters since 1970 in which the index has declined 10% or more. The average return in the S&P 500 four quarters later was 16.1% (not including dividends). In only four instances did the S&P 500 suffer a negative return 4 quarters later.
The four quarters where the S&P produced a negative return for the subsequent one-year periods were Q4 1973, Q1 2001, Q3 2001, and Q2 2002 – which correlated with recessions. While we have expected an economic slowdown for many months and the data is beginning to show it, we continue to believe that the US economy is not yet near a recession – as long as the Fed slows its rate-hiking campaign by listening to financial market signals and the emerging economic data.
For us to become worried about an approaching recession, we need to see US manufacturing and employment conditions worsen significantly more. For example, the Institute for Supply Management’s manufacturing index rose to 59.3 in November. We’d become concerned about recession if that index started to register near 50 or below. Furthermore, while jobless claims have started to trend higher between mid-September and mid-December, we believe they need to increase substantially more for the economy to be nearing recession.
Of the myriad risks and uncertainties around the world, and their potential impact on markets, we are especially concerned that markets could react negatively to political instability in the United States, stemming from the Mueller investigation.
Some pundits believe the Special Counsel will conclude its investigation during the next few months. Some reasons for the speculation is the fact that sentencings are beginning to occur, which often happens when witness cooperation is completed. Robert Ray, the former independent counsel for the Whitewater investigation, expects Mueller to deliver his report during the first quarter of 2019. CNN recently reported that the Mueller team has begun writing its final report.
All the while, the drumbeats for a Trump impeachment seem to be growing. Journalist Elizabeth Drew, who covered Watergate and believes there is enough evidence to impeach, penned an opinion editorial in the New York Times last week claiming, “An impeachment process against President Trump is inescapable.” In her view, the public pressure will grow too much for Democratic leaders to ignore. She adds that Republicans may opt for their own political survival rather than stand by the President. It could be that Senator Romney’s January 2nd critique of Trump in the Washington Post is a prelude to such a scenario.
This leads to a question that must be asked: will President Trump be removed from office in 2019?
This is a seemingly impossible variable to forecast, but needs to be considered when thinking about the direction of financial markets during the coming year. Based on the 1998 Clinton impeachment events, as discussed in previous client letters, we believe a “Trump impeachment + removal from office” scenario would lead to a 15% decline in equities.
Our base case for equity markets in 2019, however, is that this scenario will be avoided. It is probably most likely that the Mueller investigation will inflame both parties in Washington, but ultimately, given the rebuke Republicans received in the 1998 midterms, Democrats will avoid impeachment proceedings and let voters decide President Trump’s fate in the 2020 election cycle.
Meanwhile, we expect the Fed will back off its rate-hiking cycle and raise the funds rate only once in 2019, if at all; and Presidents Trump and Xi will reach a partial US-China trade deal.
Combining these conclusions to reach a base case scenario for 2019, we estimate a 15% return for the S&P 500 in 2019 -- but with intermittent volatility, notably in response to political uncertainty -- and a year-end 10-year Treasury yield of 3%. Our favorite asset classes this year are emerging markets and oil, which we expect to experience major relief from last year’s stresses.
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).
 “Why 2019 Could Be Very Good Year for Stocks, After Worst Year in Decade,” by Patti Domm, December 31, 2018, CNBC.
 “Fed Official Tries to Soothe Nervous Investors,” by Binyamin Appelbaum, December 21, 2018, New York Times.
 “Trump Hails Call with China’s Xi, Says Trade Talks Are Making Good Progress,” December 29, 2018, Reuters.
 “China’s December Manufacturing Activity Contracts Even More Than Expected,” by Huileng Tan, December 30, 2018, CNBC.
 “Schumer Response to President Trump Tweet on China Trade,” Senator Chuck Schumer, May 21, 2018, democrats.senate.gov
 “US Factory Activity Jumps in November While Construction Spending Falls for Third Month,” December 3, 2018, Reuters.
 “Mueller’s Treatment of Cooperating Witnesses Suggests End of Russia Investigation May Be Near,” by Devlin Barrett, December 13, 2018, Washington Post.
 “The End of Mueller Investigation Is Near! No, really. Anytime Now.” By Paul Farhi, December 26, 2018, Washington Post.
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