Mike Loewengart, Vice President of Investment Strategy
E*TRADE Capital Management
2018 marked a turning point in the financial markets, punctuated by volatility, trade wars, rising interest rates, and a shifting political dyanmic.
So, what does the new year hold in store? Here are five themes to follow in 2019:
1. Global growth
While most of the world’s economies are expanding and the economic outlook is generally sound, there remain obstacles to growth in 2019.
Trade wars: Over the past year, the Trump administration has slapped more than $250 billion in tariffs on China alone, but the administration has also targeted steel, aluminum, solar panels and appliances imported from other countries.1 Who is winning the trade war? Many economists would say no one, since tariffs increase the price of imports and can be an impediment to economic growth.
Budget deficits: Tax cuts enacted in 2017, coupled with increased military spending, have ballooned the federal budget deficit, which could surpass $1 trillion in 2019. Budget deficits can cause interest rates to rise, because higher yields are needed to attract creditors. Higher interest rates could, in turn, impede economic growth.
Brexit: The UK is slated to leave the European Union in 2019, but the exit terms are still murky. The 2016 Brexit vote has already been a stumbling block to growth in the UK, and a formal exit from the trading bloc could materially affect growth as well.
Bottom line: While decelerating economic growth doesn’t bode well for the markets as a whole, high-quality bonds, overlooked value stocks, and more defensive sectors could benefit.
2. US politics
November’s midterm elections resulted in a divided government, with Democrats regaining control of the House of Representatives and Republicans expanding their hold on the Senate. A divided government can result in gridlock at the Capitol, slowing the pace of legislation.
While this may frustrate voters, fewer potential bills could be a salve to investors, who would have less legislative uncertainty to navigate. Moreover, the US economy has expanded during periods of divided government before—including during the early stretches of the most recent bull market.
Bottom line: Divided government could provide a tailwind to the markets.
3. The Federal Reserve and monetary policy
The Federal Reserve has lifted short-term interest rates three times this year but has hinted at slowing the pace of monetary tightening as rates move closer to neutral.
Inflation: Consumer price inflation hasn’t risen significantly of late, but it is running at the Fed’s target rate of 2%. Until inflation moves lower, the Fed could continue to raise rates.
Unemployment: The US unemployment rate dipped to 3.5% in the third quarter and has remained close to that figure since. With unemployment at a 49-year low, additional gains in an already-tight labor market seem unlikely. Given stiff competition for workers and talent, wage inflation is the more pressing issue. Whether low unemployment causes wages to continue rising remains to be seen.
Interest rates: Could higher rates inhibit economic growth? Keep in mind that the Fed is tasked with promoting maximum employment and keeping prices stable; economic growth isn’t among its mandates.
Bottom line: A more normalized rate environment could provide the Fed with additional dry powder to expand monetary policy by lowering interest rates if needed.
4. Bond markets
Despite higher rates, bonds lost only nominal amounts in 2018, and short-term Treasuries provided much-needed stability when stocks sold off in the third quarter.
Treasury yield curve: Investors remain concerned about the flattening yield curve, as an inverted yield curve can signal that a recession is on the horizon. Recently, parts of the short end of the curve have, in fact, inverted. However, there are two important caveats: First, parts of the yield curve do invert from time to time, and the most-watched portion between 2- and 10-year Treasuries is not inverted at the time of this writing. Second, even in times of a more pronounced curve inversion, a recession is typically one to two years off.
Investment-grade, high-yield bonds: Higher short-term rates could provide income opportunities with lower risk than more rate-sensitive long-term bonds and income-oriented equities. And, unless the economy falls into recession, default rates are likely to stay low. This could make corporate bonds attractive, although credit spreads are still quite tight.
Bottom line: Higher rates could provide investors with additional yield opportunities, and there are certainly relative value opportunities available.
5. Equity market leadership and economic fundamentals
In August, a long-running equity bull market became the longest on record since World War II. Since then, however, stocks have been roiled by volatility. Will the markets remain unsettled in 2019?
Growth vs. value: Growth stocks have outperformed value shares for the better part of the past decade, including the past year. However, given the Fed’s more restrictive monetary policy, it remains to be seen whether growth stocks can continue their pattern of dominance—especially since value stocks have the potential to outperform in more defensive environments that emphasize individual stock selection.
Small caps vs large caps: At the onset of the current trade war, it was thought that tariffs would affect large, global firms more than small companies with US-focused operations. Nonetheless, small caps have underperformed large caps in 2018, and we appear to be late in the business cycle. If the economy slows, large caps could be better positioned to navigate more challenging long-term market conditions.
US vs international equities: On the heels of a strong 2017, international equities disappointed in 2018. But with compelling valuations and low correlations to US equities, international equities have important implications for portfolio diversification.
Bottom line: Valuations for both international equities and value stocks remain compelling.
Fundamentals still matter
With the midterm elections in the rear-view mirror, investors finally have at least one issue of uncertainty resolved. A November E*TRADE survey found that more than half of survey respondents—particularly young investors—expected the midterm results to benefit them financially. Nonetheless, headwinds remain in the form of ongoing trade disputes, higher interest rates, and soaring budget deficits that leave few fiscal tools available to fine-tune the economy.
While large-cap growth stocks led the bull run in previous years, in 2019 this could change if the market stops advancing in lockstep and assets become uncorrelated. In that environment, individual stock selection and a focus on company fundamentals could come to the forefront.
Vice President, Investment Strategy
E*TRADE Capital Management, LLC
Mike Loewengart is the Vice President of Investment Strategy for E*TRADE Capital Management, LLC. Mike is responsible for the asset allocation and investment vehicle selections used in E*TRADE’s advisory platforms. Prior to joining E*TRADE in 2007, Mike was the Director of Investment Management for a large multinational asset management company, where he oversaw corporate pension plan assets. Early in his career, Mike was a research analyst focusing on investment manager due diligence for the consulting divisions of several high-profile investment firms. Mike holds series 7, 24, and 66 designations, as well as the Chartered Alternative Investment Analyst (CAIA) designation. He is a graduate of Middlebury College with a degree in economics.