Ever since I was a kid, I've liked race cars, especially the speed and skill of the drivers as they pass one another. The excitement of setting new records always fascinated me. It reminds me of this bull market, pushing forward and setting new records — until last year, when we hit a speed bump. While the race car may have been the best vehicle to travel in for the past 10 years, I think an SUV may be a more appropriate vehicle for investors in 2019, still pushing them forward but providing more cushion for what is expected to be a bumpier ride.
After a challenging and volatile 2018, we believe 2019 will be a year of transitions: to slower economic growth, a removal of financial liquidity (though at a more measured pace) and more modest return expectations. One constant, however, will be a continuation of the market swings that appeared in the final months of 2018. Volatility should persist in light of uncertainties around trade, the shift from quantitative easing to quantitative tightening, and geopolitical and political events that could result in periods of risk aversion.
Central to our outlook is our expectation that the long global expansion will endure, albeit at a slower pace as fiscal stimulus fades in the U.S. and tighter financial conditions weigh on growth. For 2019, the U.S. economy should deliver real gross domestic product (GDP) growth of 2%, while global real GDP should come in near 3.5%. We expect that this backdrop of slowing but positive global growth, a solid pace of earnings growth, and only modestly higher interest rates should enable financial markets to deliver moderate gains for the year.
There are several themes that will help shape the markets and our strategic investment positioning in 2019:
Fading Global Liquidity
After a decade of extraordinary measures to stimulate the economy, the Federal Reserve has continued to lead global central banks in removing monetary stimulus from the global monetary system. The Fed has been raising short-term rates since December 2015, with its most recent quarter-point increase in December bringing the federal funds rates to a range of 2.25% – 2.50%. The central bank also began reducing its balance sheet by an initial $10 billion per month in 2017, increasing this level to $50 billion per month in October 2018.
In its December meeting, the Fed reduced the expected number of rate hikes in 2019 from three to two and confirmed an unwinding of its balance sheet at the same pace. However, recent Fed commentary suggests a more patient central bank. As a result, the futures market is forecasting that the Fed will pause throughout much of 2019. We'll likely see the central bank's own projections move down as well. Unlike previous rate hikes, which were driven by the Fed's desire to normalize interest rates and below-target inflation expectations, we believe the Fed will need to rationalize future actions with supporting data. Given slower global growth and uncertainty surrounding trade and politics, our base case is that the Fed increases rates only once in 2019.
Although some central banks, such as the Bank of Japan and the People's Bank of China, remain accommodative, other central banks, such as the European Central Bank and the Bank of Canada, are transitioning from quantitative easing to quantitative tightening. We anticipated that this global tightening would play a role in slowing economic growth and increasing volatility within financial markets, as we witnessed in late 2018. While we expect this transition to continue, we expect a more measured pace of tightening.
Wage Inflation Pressures
Well-contained inflation has enabled the Fed to raise short-term rates gradually up to this point. The central bank's preferred measure of inflation, the Personal Consumption Expenditures index excluding food and energy, is up 1.8% year-over-year through November. We're likely to see inflation data soften from current levels near term given the near 45% decline in the price of crude oil since hitting a high of $77 in 2018. While we only expect modestly higher consumer prices during the year, we remain watchful of wages pressures, which have remained relatively muted during this recovery. In December, average annual earnings grew 3.2% year over year. So while wages have barely kept up with inflation thus far, they could surprise to the upside. As unemployment levels fall and companies have more difficulty finding qualified workers, we might finally see pressure on wages.
Yield Curve Dynamics
The yield curve dynamic is a theme we've carried over from 2018, as the shape of the yield curve and what it may signal about the economy remains an important variable we are watching. At the end of last year, a partial inversion of the Treasury yield curve, a fairly reliable historical predictor of economic recessions, had markets on edge. While the spread between the three-month and two-year Treasury yields inverted for a short period, we prefer to measure the shape of the curve by the three-month to 10-year Treasury note yields, a curve that still remains positive. The yield curve will likely continue its flattening trend in 2019, led by the short end of the curve, while long-term rates should only drift modestly higher. With our belief that the yield curve will remain upward-sloping, we conclude that the curve is suggesting that a recession may be years away.
Volatility is a theme we have included in our annual investment pillars for several years as we entered the mid-to-late stage of this bull market. Given the transition from a period of quantitative easing to quantitative tightening, the potential for a trade war with China, and increased political disruption both in the U.S. and abroad, we expect volatility will persist in 2019. It is not always possible to know when bouts of volatility will occur, which is why investors should resist the temptation to sell out and abandon well-thought-out investment strategies. While market downturns are never pleasant, rebounds often occur quickly after selloffs, resulting in investors who sold at the lows missing out on the subsequent recovery. Instead, investors should stick to a long-term investment plan that is tailored to their wealth objectives. Remaining invested will give them the best chance to harness the power of compounding and generate additional returns in the long run.
To buffer volatility, we have proactively equipped portfolios with lower-correlated strategies and emphasized the importance of diversification and rebalancing. We also believe our current, neutral posture in equities will provide us with the most prudent balance of risk and return.
Moderate Equity Gains
In 2019, we expect a slowdown in earnings growth from the robust levels seen over the last four quarters as one-time tax benefits fade and economic activity slows. Operating earnings for S&P 500 companies should range between $165 and $175. With the backdrop of slightly rising interest rates, we expect little in the way of P/E expansion, the amount investors are willing to pay for future earnings. We believe, however, that a solid earnings backdrop will more than offset a flat P/E multiple, resulting in moderate equity gains for 2019.
The 2018 year-end market sell-off pushed valuations down to below 20-year averages for domestic and non-U.S. equities. The S&P 500 is currently trading at a price/earnings multiple of 14.9x forward 12-month earnings and provides a dividend yield of approximately 2%. Smaller capitalization stocks are trading at 15.8x, well below their average of 18.3x. Meanwhile, international developed and emerging market equities are trading at 12.5x and 11.0x, respectively — just below their 20-year average of 13.7x and 11.5x.
The decline in bond yields and the pullback in equity prices has also changed the dynamics in the risk-versus-reward trade-off between stocks and bonds. One measurement we utilize to gauge the attractiveness of stocks over bonds takes the earnings yield (i.e. the inverse of the P/E ratio) and subtracts the 10-year Treasury yield. The higher the number, all else being equal, the more attractive it is to hold equities. As we began 2019, this number was roughly 350 basis points, a value which is near the upper end of its historical range, signaling the attractiveness of equities over bonds.
Geopolitical and Political Risk
We continue to watch geopolitical events that may cause periods of risk aversion or result in a change to our outlook. Trade policy is top on our list, as we watch to see whether U.S.-China trade talks improve or worsen. Central bank overtightening is another risk we are monitoring, but for now the Fed appears patient about raising rates further depending on what data reveals about the pace of economic growth and inflation. Political disruptions — whether a hard Brexit, instability in the U.S. regarding the government shutdown or even the increased likelihood of additional investigations on the Trump administration — could cause markets to become volatile. We will continue to remain alert to any change in risk that may adjust our outlook.
All things considered, we have a cautiously optimistic outlook for the global economy and financial markets as 2019 gets underway. We expect positive but moderate equity and fixed income returns. However, given the potential risks to growth and expectations for continued volatility, we believe a more balanced, diversified and active approach to investing will be required.
Our recommended portfolio positioning of a neutral weight to equities, an emphasis on yield within a diversified mix of fixed income holdings, and the inclusion of lower-correlated investments should provide investors with the most prudent balance between risk and return. This positioning should also give us the flexibility to best navigate what may come next during this later stage of the economic and business cycle. Importantly, investors should ensure that their investment plan meets their financial and wealth goals, while taking into consideration their tolerance for risk. This is most likely to be a year when diversification, rebalancing and action, rather than inaction, should be rewarded for those who remain disciplined to their investment strategy. In other words, best to buckle into the SUV.