What do you expect to be the key driver of stock market performance in 2019?
China's declining economy and plunging markets will continue to surprise the US market, sustaining the current sell-off. I suggested last year that this was likely to happen (Kevin Wilson, 2017). This will mainly be driven by tighter than expected fiscal and monetary policy in China, which will result in lower levels of capital investment. Falling consumer demand is also part of the Chinese slowdown and its impacts (Kevin Wilson, 2018). The cumulative effects of the trade war will substantially exacerbate the economic damage, even if a truce is called in the next three months. In 2019, China will likely experience its first real taste of the downside of capitalism (i.e., a recession) in several decades. This will have huge spillover effects in Australia, Canada, Brazil, Europe, and elsewhere.
As we approach 2019, are you bullish or bearish on U.S. stocks?
I am very bearish on the US stock market (NYSEARCA:SPY), (NYSEARCA:DIA), (NASDAQ:QQQ) because of: a) the extreme over-valuations; b) very poor market internals; c) significant technical damage that was incurred during the recent sell-off; d) very high long positions in the futures markets (a contrary indicator) despite the recent sell-off; e) relatively low fear indications (e.g., the VIX index) amidst very high volatility; f) signs of an impending drop in profit margins and net income; g) signs of the pending demise of the massive stock buyback programs that have driven this bull market for years; h) decreasing market liquidity amidst a Fed tightening cycle; i) waning support for corporate profits from Trump's fiscal stimulus package; and j) a decline in the rate of federal deregulation actions that could help the markets, as the US House and Senate are split between the parties and a period of gridlock begins.
Which domestic/global issue is most likely to adversely affect U.S. markets in the coming year?
A financial crisis in Europe is possible due to the potential collapse of the European banking system (cf. Chart 1). This would likely be initially centered on Italian banks but would spread rapidly to Germany, Spain, and France as a moderately deep global recession takes hold during 2019.
Chart 1: Declining Credit Quality at Italian Banks Poses Systemic Risks
How does the political climate affect the risks and opportunities for next year?
The boost to markets from US fiscal stimulus will end because of government gridlock. Dreams of a new infrastructure spending program will evaporate in the currently poisonous political climate. The planned onslaught of some 100 House Democratic committee investigations will likely curtail whatever the Trump Administration's momentum has been on health care and tax reform. The political confrontation over immigration and border security will probably not be resolved, and it is possible that President Trump will intermittently close the border in response to what he views as Democratic obstructionism on this issue. The trade war with China is capable of escalating into a major problem for the global economy, and that economy already has a major problem (i.e., global overcapacity amidst falling demand).
Do you expect the yield curve to continue flattening in 2019, and if so what impacts will that have on the equity market and the economy in general?
The UST5Y-UST2Y part of the curve has already inverted (Chart 2). Broader portions of the yield curve will also likely invert in the near future. Fed policy, which includes both rising rates and "QT," will continue to drive deep concern in the bond markets. This may not affect equities except psychologically, because markets often rise for months after yield-curve inversion. However, that does not mean that markets must rise, only that they could. Lag time between yield curve inversion and the onset of recession varies from six to 24 months (Alister Bull, 2018). The shorter the lag, the earlier the bear market collapse. Also, I think the lag this time could be much shorter than it was in 2008, because the Fed has manipulated the bond markets and rates almost continuously for ten years now, and rates are still relatively low, leaving little room for boosting liquidity further than it has already gone. So I believe a recession will begin in mid-2019, far sooner than many people expect. The impact on stocks (SPY), (DIA), (QQQ) will be profound.
Chart 2: UST5Y-UST2Y Yield Curve Inversion
Typically, when the term spread for the UST10Y-UST1Y part of the curve drops to zero, Federal Reserve researchers have shown that recession probability rises to about 24% (Michael D. Bauer & Thomas M. Mertens, 2018). That term spread is currently only 19 bp and is on a steeply declining trend. If the Fed raises rates this month, that spread could shrink some more or even turn negative; further reports of declining economic activity could have much the same effect. Once this Fed probability measure reaches about 30%, historically a recession has been quite likely (Chart 3).
Chart 3: Recession Probability (to February 2018) Based on the Yield Curve
The global yield curve has long since (June 2018) inverted (Chart 4), according to both Bank of America and JPMorgan Chase & Co. analysts (Robert Burgess, 2018). This suggests that a global recession is either imminent or has already started. The notion that the US can avoid getting caught up in a global recession is unrealistic; indeed, in an interconnected global economy, there are no hiding places for major players.
Chart 4: Global Yield Curve Inverted Months Ago (June 2018)
In terms of asset allocation, how are you positioned heading into the New Year?
I believe that downside risk is 65%, based on extreme valuations (cf. John Hussman, 2018). Therefore my portfolio is positioned extremely defensively right now: 49% long bonds [Wasatch-Hoisington Treasury Bond Fund (MUTF:WHOSX); I-Shares 20+ Year Treasury Bond Fund (NASDAQ:TLT)]; 33% cash, 9% gold [SPDR Gold Shares (GLD)]; 5% assorted individual stocks, and 4% long/short funds [Otter Creek Long/Short Fund (OTCRX)].
What 'surprise' do you see in the market that isn't currently getting sufficient investor attention?
There is insufficient liquidity in the system to support all of the potential panic selling that will come when the various nearly one-sided bets out there eventually blow up. For example, there are now trillions of dollars in stock index ETFs, almost all of which have very low cash on hand. These have already been hit hard, and they will continue to take it on the chin preferentially as the market falls, based on their inherent structure. There is the possibility of a waterfall event as these funds flood the market with sell orders in response to panic-driven redemptions. Margin calls on record margin debt will exacerbate the selling and the illiquidity. Worst of all perhaps, some high yield ETFs are highly illiquid in practice and will not be able to handle redemptions in a timely manner. The combination of these factors suggests panic selling will cause the market to overshoot to the downside in the near future, which might mean losses could substantially exceed 65% on the S & P 500.
What role will the Fed play in the coming year?
The Fed will reverse their present stance and switch over to damage control early in the year. It is likely that rates will pause in their rise fairly soon, and even start falling by mid-year or sooner. The "QT" program will likely transmogrify into a "QE" program by late in the year. None of this will make the slightest difference, just as similar moves made no difference in 2008 and 2000 (cf. Chart 5).
Chart 5: Sharply Falling Rates in 2008 Had No Effect on the Market
What issue is receiving too much investor attention, or is already priced in?
The trade war is not what will drive the economic slowdown; instead, it will serve merely to exacerbate it. Wall Street and retail investors should keep their eyes instead on China's economic decline and its policy response, and Europe's potential for setting off another financial crisis.
Disclosure: I am/we are long GLD, OTCRX, WHOSX, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.