2018 Market Commentary And 2019 Outlook - Vigilante No More

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Includes: ACWI, AGG, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Benjamin Lavine, CFA
Summary

The fourth quarter started poorly with "risk-off" positioning across global markets. Global equities dropped following negative headlines surrounding Federal Reserve tightening, China slowdown, and ongoing trade disputes between the U.S.

Cyclical risk assets sold off as investors sought safe havens such as low volatility sectors (utilities, telecom, real estate), U.S. Treasuries, and precious metals.

The health of the U.S. credit markets deteriorated due to concerns over Fed interest rate policies and high-profile downgrades/bankruptcies (i.e., credit rating downgrade of GE and Sears bankruptcy).

We would expect U.S. stocks to track earnings growth but would not expect a higher valuation paid for that earnings growth.

Going forward, market pricing may push risk premiums into extreme complacency or fear over the short-run, but current market prices reflect a more balanced view of risk and reward.

Data Source: Bloomberg

2018 Year-End Market Commentary and 2019 Outlook - Vigilante No More

Source: istockphoto.com

Note to readers: We have sectioned the 2018 Year-End Market Commentary and 2019 Outlook accordingly:

1. Big picture outlook and key issues heading into 2019

2. Summary 2018 year-in-review

3. Final thoughts and our base case estimate of the path forward

4. Supplemental charts and exhibits

2018 Ends with Investors Staring into the "Risk-Off" Abyss

From a global investor's perspective, the best that can be said about 2018 is that it is finally over (although one is hard-pressed to find an investor looking forward to 2019). Very few risk-based assets performed positively in 2018 (Figure 1).

Figure 1 - 2018 Performance of Asset Class and Styles (Descending Order)

Source: Bloomberg

But a bad year does not mean that investors can continue to pretend that asset prices are divorced from reality. Just as market performance throughout 2017 and the beginning of 2018 witnessed animal spirits taking market valuations to unrealistic levels, today's depressed pricing environment has produced more attractive (or perhaps more realistic) valuations despite daily angst over global trade disputes, Brexit, China slowdown, Federal Reserve overreach, and a credit market shutdown.

Heading into 2019, investors are truly staring into the risk-off abyss, with the abyss staring back at them with more attractive valuations amidst a more sobering macroeconomic and political backdrop.

From Vigilante to Addict: A Role Reversal for the Bond Market

"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody." - Former Bill Clinton Political Advisor James Carville in the Early 1990s (Source: Barron's 9/26/2018).

Back in September 2018, Barron's Up-and-Down Wall Street columnist Randall Forsyth resurrected Carville's famous quote when, referring to a Bank of International Settlements ("BIS") report, Forsyth warned readers how "credit in the world's bond markets [had] ballooned to what many observers [considered] to be dangerous proportions."

However, rather than playing the 1990s role as vigilante to excess spending and debt issuance, the bond market is playing the role as helpless victim, crying to the U.S. Federal Reserve ("the Fed") that the world economy cannot withstand positive real interest rates and a withdrawal of U.S. dollar liquidity resulting from the reversal of quantitative easing.

Just as a petulant child tests the resolve of his/her parents determined to wean said child off years of spoiled living, the equity and credit markets are testing the resolve of the Fed to pursue its real neutral rate of interest target (estimated at 1% assuming 2% core inflation) as well as paring back its balance sheet which had ballooned to nearly $4.5 trillion from $1 trillion prior to the 2008 Financial Crisis (Figure 2).

Figure 2 - Federal Reserve Balance Sheet: The Painful Path Towards Normalization

Source: U.S. Federal Reserve (Period Ending 12/19/2018)

However, in reference to the BIS report, global financial markets resemble more of an addict than a petulant child. According to Forsyth, "nonfinancial credit…increased to 38% of global gross domestic product [as of 1Q2018], up from 33%...three years earlier," and that "the makeup of global capital shifted to debt securities, whose share soared to 57%...up from 48% in the onset of the financial crisis a decade ago." The spectacular growth in nonfinancial credit has produced a bond market that is addicted to quantitative easing ("QE") and zero interest rates ("ZIRP").

U.S.-dollar denominated debt (U.S. corporate-issued and foreign borrowings) has exploded. Forsyth concluded his column by warning that "Instead of being all-powerful, bloated bond markets could be the key source of weakness in the next crisis."

From vigilante to addict, the bond market's signal to the Fed is to forget about normalization of monetary policy as if the world is still functioning in the post-WWII era of business cycles prior to the 2008 Financial Crisis.

Does the Fed Blink in a Monetary Stand-Off with the Market?

So, we end 2018 and enter 2019 with a stand-off between a QE/ZIRP-addicted market and the Federal Reserve over the near-term direction of monetary policy that will have implications for the pricing of risky financial assets (equities, private credit, commodities). A more cynical take would picture the standoff more as a struggle between the addict and the rehab clinic trying to administer methadone. An even more cynical take would be to affirm that the New Normal secular disinflationary conditions of global excess debt levels, aging demographics, and manufacturing capacity have, once again, prevailed over cyclical reflation; and that the best investors can hope for is a global economy characterized by low nominal growth without tipping over into recession.

We first wrote about the tectonic forces of New Normal secular disinflation fighting cyclical reflation back in our 2016 Year-End Market Commentary. The questions we posed back in early 2017 are still relevant today, but the answers seem to be changing from year-to-year:

Can the incoming U.S. administration reverse the New Normal overhang on U.S. business production and how will such a reversal manifest itself?

  • 2017: "cyclical reflation" appeared to be prevailing; 2018: ?? Will a new round of inflation be unleashed as the [Trump] administration seeks to roll back government policies regulating large swaths of the industrial sector, freeing pent-up growth, but also unleashing demand that could push up prices?
    • 2017: it appeared that way; 2018: core inflation rose to 2.1% before trending back down as corporations blew their tax savings (and increased their debt borrowing) on share repurchases. Will the Fed's goal to normalize monetary policy and pre-empt cyclical inflationary pressures by pursuing a more aggressive rate hike policy help subdue any macro credit bubbles that could form during a cyclical recovery?
      • 2017: what macro credit bubbles? 2018: Oh…those macro credit bubbles.

Looking back at our 2017 Year-End Market Commentary, we identified the Federal Reserve and China as posing the two largest risk factors to global market performance (admittedly, these weren't exactly "sticking-your-neck" out calls, although we didn't include the Trump Administration as another risk factor). But we also acknowledged the prevailing overhang of New Normal risks despite a rosy cyclical outlook.

In other words, we 'hedged' our cautiously optimistic outlook for 2018 by writing:

"Heading into 2018, 3D expects cyclical reflationary trends to prevail over the 'New Normal' secular disinflationary trends although the magnitude and when the cycle turns may depend on the following:

Monetary policy under a new Federal Reserve Board, chaired by Jerome Powell, and how the Fed will continue its rate tightening campaign so as to stay ahead of the inflation curve but not overtighten rates that would push the economy into recession. Debate (and political reception) of Trump Administration initiatives to boost the economy, primarily the impact from tax reform legislation. China's ability to engineer 'higher quality' GDP growth by unwinding its excess leverage without causing a systemic meltdown of its financial system."

What we neglected to incorporate into our outlook was the psychology of market confidence (or lack thereof) which produced a wide pendulum swing between greedy over-expectations/complacency (first half of 2018) and fearful under-expectations/"get-me-out-no-matter-what-the-price" (4Q2018). Market psychology can have an enormous impact over the short-run, and tactical investment strategies whose models are generally built on market sentiment are enjoying the fruits of their defensive positioning (assuming the models moved to cash in the face of declining risk appetite).

Market psychology also separates a market regime influenced more by "fundamentals" versus "reflexivity." The latter posits that market pricing can affect, rather than reflect, market fundamentals. When market psychology turns from greed to fear, market liquidity turns from overly abundant to a shut window, regardless of how corporate fundamental health may or may not be at any given point. This invariably creates a virtuous or vicious cycle whereby company fundamentals become more dependent on market volatility rather than the broader macroeconomic backdrop.

Advocates of the efficient market hypothesis ("EMH") like Fama/French would dismiss the psychological notion of "reflexivity" as characteristic of market pricing since EMH views market pricing as the most effective mechanism for capturing the fundamental backdrop. But EMH can suffer over the short-run, whether by excess irrational behavior or through a systemic shutdown in liquidity. The latter is what gives heft to reflexivity - if companies find themselves shut out of the capital markets, then their fundamentals will deteriorate beyond levels initially feared by the markets, creating that vicious cycle. It is at these moments that the Fed, U.S. Treasury Department, and banking regulators need to be most keenly aware and be able to judge liquidity issues from fundamental deterioration.

At the risk of sounding hackneyed, global risk appetite will likely recover when the markets stop selling off in the face of bad news and negative headlines. Sellers will have exhausted themselves and buyers (those with fresh powder capital) will find valuations so compelling as to overlook any lingering negative overhangs. This could take the form of the Fed acknowledging the weakness being expressed by market volatility and widening credit spreads, or the markets shaking off their current malaise and acknowledging the rosy economic outlook built into the Fed's models.

But investors' resolve will likely continue to be tested throughout 2019 until they receive more clarity on major market overhangs, such as China's economic outlook and how aggressive the Fed will pursue policy normalization.

Key Questions and Challenges Facing Investors in 2019

We provide more of our thoughts concerning our market outlook at the end of this article, but we have updated our key questions heading into 2019.

Will a split U.S. government characterized by increasingly partisan political factions drive up the cost of debt financing (both for the U.S. government and for private borrowers)? With the U.S. fiscal deficit approaching $1 trillion in FY 2019 (or 5% of the U.S. economy), will unchecked growth in U.S. government debt, now comprising almost half of the investment-grade fixed income benchmarks such as the Bloomberg Barclays Aggregate Bond Index, crowd out private borrowers, resulting in even higher borrowing costs? Facing higher borrowing costs and the threat of downgrades from credit rating agencies, will heavily financial-leveraged companies go on a balance sheet diet that may result in reduced share repurchase and dividend activity (see " The Growing Risk to Dividend-Paying Strategies")? Having been identified as the proximate cause (but not the primary cause) of pushing the U.S. economy into recession during the last three rate hike cycles, will the Fed move more cautiously on pursuing its goal of normalizing monetary policy by raising the benchmark rate to the "neutral" level (estimated between 0.50% and 1% real rate assuming 2% inflation) and further reducing its $4 trillion balance sheet?

At what point will the Fed "course correct" on its rate hike outlook, assuming that market volatility and credit spread widening are correctly foreshadowing a significantly weaker macro environment than what the Fed is modeling? How dependent are risk-based assets on Chinese fiscal and monetary stimulus? Has China's financial leverage reached an inflection point where China must focus on servicing its debt, resulting in a slowing economy? Can this be done without producing a global financial contagion that brings the rest of the world down with it? After a decade of low nominal interest rates, where will the next credit bogeyman surface? Is there hidden credit risk lurking somewhere on consumer and/or corporate balance sheets?

2018 Year in Review: Another Strong Year for Growth Momentum Style of Investing

1Q2018 - Mission Accomplished (Updated March 2018)

Global markets started off the year on a strong foot following the robust performance in 2017. The beginning of the quarter saw a euphoric start for global equities as investors celebrated the passage of the Republican tax plan that lowered the tax burden for U.S. corporations, as well as optimism over capital spending plans. The U.S. dollar continued its 2017 weakness throughout January, while risk-based assets such as commodities saw large gains (1-month spot market oil prices reached $64/barrel).

However, the market regime abruptly shifted following the January employment release. Investors were spooked over the rising wages component of the report that sparked initial inflation fears, resulting in the 10-Year Treasury Yield rising as high as 2.95% before settling down to 2.75% at quarter-end. TIPs/nominal Treasury spreads were now starting to price in 2%+ long-term inflation.

At the end of January, we argued that investors had front-loaded about half their annual performance following the strong run in January (Clipping Half Your Coupon). That assumed no change to the underlying risk regime, which abruptly shifted following January's month-end employment release and subsequently throughout the year, culminating in the fourth quarter sell-off.

February saw a major unwind of the so-called short volatility trade following the January employment release. Investors betting on tight risk premium pricing and the continuance of low volatility were caught off guard. Those shorting the S&P VIX via exchange-traded portfolios lost most of their investment. Global markets did recover from the initial bout of selling in early February as corporate earnings outlook helped support investor sentiment despite the threat of higher interest rates and global central banks' willingness to "normalize" their monetary policies. Indeed, we wrote about the removal of the Fed Put and its replacement, the Fed Strangle (coined by Stifel Strategist Barry Bannister), in our February 2018 Market Commentary - Inflation: The Fed's MacGuffin.

March saw further selling over technical pressures such as a key corporate funding signal (LIBOR-OIS spread) rising to stress levels not seen since 2009, as well as the emergence of trade disputes between the U.S. and its major trading partners. U.S. large growth outperformed value for the quarter but that outperformance narrowed towards the end of March. Small cap outperformed large cap after having lagged for much of the quarter. Technology and consumer discretionary sectors were the only positive sector performers for the quarter, although they gave back some of their gains in March.

2Q2018 - "Trade Dispute" Not "Trade War"

The second quarter of 2018 saw global equity markets lose some ground from the first quarter, much of it attributed to the growing trade war dispute that took shape throughout the quarter between the U.S. and the rest of the world. MSCI All-Country World Index ended the quarter with a slight gain of 0.53%, but much of the gains came from the U.S. market. The trade-weighted U.S. dollar also recovered from its early 1Q weakness and would reverse much of its 2017 weakness as global investors began to exit international markets, notably emerging markets.

Diverging monetary policies between the U.S. (rate tightening) versus the rest of the world (Japan and Europe remain in quantitative easing mode) caused concerns that the rest of the world would not be equipped to shoulder the higher interest rate burdens and reduced dollar liquidity from U.S. Fed tightening, especially for foreign borrowers that had issued dollar-denominated debt.

Global trade "disputes" became a greater reality for investors. Of the worldwide tariffs announced through second quarter-end between the U.S. and her trading partners, the Tax Foundation had estimated that long-term U.S. GDP would decline 0.44% along with negative impact on wages and employment. Apart from trade disputes, the Fed remained the primary concern among investors as prior tightening regimes had ended with the U.S. in recession and the rest of the world suffering from the loss of liquidity.

The commodity complex bucked the concerns weighing on other cyclical risk assets. Led by oil prices (one-month generic rallying to $74/barrel), commodities had generated another strong quarter and were one of the best performing asset classes for the first half of 2018. Oil prices had rallied due to supply concerns stemming from Libya (dispute over oil-marketing rights) and Iran (sanctions-related) as well as major oil producers, Saudi Arabia and Russia, agreeing to raise output "less aggressively" than had been anticipated. The global oil supply/demand picture had returned to balance after operating in a net deficit over the prior year. However, "demand" was starting to feel the impact from high oil prices while "supply" was increasing in response to higher oil prices. We warned that commodity investors banking on further oil price rallies should be mindful of a potential tapering off in demand.

U.S. fixed income presented a mixed picture of U.S. inflation and growth. The core component of the personal consumption expenditure (PCE) price index had reached 2% growth on a year-over-year basis which, along with a strong employment environment, gave the U.S. Fed ammunition to pursue rate tightening. But widening investment grade credit spreads and a flattening Treasury term structure suggested financial conditions had tightened to a point where the risk of deflation had started to emerge. If inflationary pressures had peaked, then we could have envisioned a scenario where investors would start gravitating back into long duration Treasuries and other safe-haven assets (i.e., the Japanese yen) as a hedge against future market volatility.

Indeed, risk-off defensive posturing had started to take hold, and that stance would prevail throughout the rest of the year. In a somewhat contradictory fashion to commodity prices, defensive, rate-sensitive sectors such as REITs and utilities performed well during the quarter. Much of this rally occurred late in the quarter as investors moved to more defensive positioning considering the elevated trade war rhetoric and retaliatory tariffs.

We concluded our first-half outlook that would presage the volatility experienced during the second half:

"Is the Trump 'trade dispute' enough to push key macro and market risk indicators into deflationary territory? We may get a glimpse over the summer, but investors should keep an eye on the term structure and credit spreads as early clues that the U.S. economy may slow down enough for the Powell Fed to hit the pause button on the rate hike schedule. The Fed may find itself in a bind if headline inflationary figures, driven by higher oil prices, remain elevated above the 2% comfort zone. This should make for an interesting summer."

3Q2018 - International Gains Ground as Trade Tensions Ease

Global equity markets continued their slow advance with an increasing divergence between the S&P 500 Index (up 7.7% for the quarter) versus MSCI EAFE (1.4%) and MSCI Emerging Markets (-1.1%). The quarter was characterized by a narrowing advance of U.S. large cap growth stocks with mid- and small-cap stocks falling behind.

U.S. "value" and "dividend" style factors underperformed as the former suffered from the poor performance of the financial sector (notably bank stocks) despite higher interest rates, which normally help bank profitability. Dividend stocks and REITs came under pressure as the 10-year Treasury yield rose to as high as 3.10% before settling just above 3% at quarter-end. The rise in interest rates also pressured fixed income indices, although U.S. high yield continued its outperformance as credit spreads for the riskiest borrowers continued to narrow.

The Federal Reserve hiked its benchmark rate to 2.00-2.25% at the September meeting and removed the "accommodation" term from its communique, a move which some Fed analysts interpreted as a dovish signal that the end of the rate hike cycle may have been near. One would not have been unreasonable to expect the Fed to act more cautiously when raising rates to make sure that the U.S. economy, post 2008, could withstand a positive real rate environment and not roll over into recession. However, as we saw in the fourth quarter, the Fed (notably Jerome Powell) made some hawkish comments that sent the markets into a tailspin throughout the quarter.

Late in the third quarter, the U.S. and Canada reached a last-minute accord to revise the North American Free Trade Agreement (NAFTA). The accord allowed Canada to join a revised agreement reached between the U.S. and Mexico in August. "NAFTA 2.0" represents a significant revision of the original NAFTA agreement, with the biggest impact expected in the automobile sector. For instance, the new agreement requires a greater portion of vehicles to be made in North America with higher wage labor sourced in the U.S. and Canada. Canada will also curb protection of its dairy industry in return for the U.S. dropping its demands to scrap the original treaty's Chapter 19 provisions allowing member states to challenge trade restrictions imposed on the others.

Despite underperforming through most of the third quarter, emerging markets recovered some of their relative performance in late September. Some attributed the recovery in emerging markets to investors taking advantage of oversold conditions and cheaper valuations, as well as positive central bank policy responses, including Indonesia, Russia and Turkey. Investors also expected Chinese stimulus measures to soften the impact from U.S. tariffs.

4Q2018 - Will Market Meltdown Force the Fed to Blink?

The fourth quarter started poorly with "risk-off" positioning across global markets. Global equities dropped following negative headlines surrounding Federal Reserve tightening, China slowdown, and ongoing trade disputes between the U.S. and China. Investors were also spooked with rising interest rates as U.S. Treasuries rose as high as 3.22% in early October.

The prospect of more trade tariffs (and perhaps general political uncertainty), as well as tighter financial conditions brought on by higher interest rates and widening credit spreads, seemed to drive a pullback in the appetite for future capital spending. Additionally, the world's second largest economy, China, appears to be experiencing a significant slowdown due to a combination of deleveraging, regulatory actions favoring state-owned enterprises over the private sector, and the diminished prospects that the trade dispute with the U.S. would be resolved in the near-term. Despite reports that China had pulled back on borrowing and investment (the opposite actually happened), China faces dim prospects in 2019 due to higher cost pressures, elevated inventories, and poorer credit metrics (i.e., spike in late interest payments).

The U.S. and China did agree to momentarily lay down their "trade bazookas" following the G20 dinner with China agreeing to increase purchases of U.S. farm and energy products and the U.S. holding off on further tariff increases for 90 days. However, larger issues such as resolving China's mercantilist practices (forced technology transfers, violation of intellectual property rights, support of state-owned enterprises) as well as geo-strategic issues (South Seas Island expansion) will likely not be resolved over the next 90 days, which could see trade conflicts flare up again in 2019. In addition, China still faces the prospect of having to manage its overwhelming financial leverage; while pursuing longer-term efforts to de-lever its economy such as its Blue-Sky initiative.

Financial conditions for Corporate America are also tightening, which may be a harbinger of a broader economic slowdown. Corporate credit spreads widened in sympathy with the global equity sell-off, but also over some negative headlines such as Sears filing for bankruptcy, and the credit rating downgrade of GE that had effectively shut GE out of the commercial paper market.

Following the October sell-off, Powell backtracked his hawkish October comments by hinting that the Fed may need to slow down the pace of rate hikes in 2019; and then suggested that the current interest rate level is "just below" the theoretical neutral rate of interest. That seemed to open the door for the market rally over the second half of November. Prospects for a Fed "pause", combined with the outcome of the G20 dinner meeting between U.S. President Donald Trump and Chinese President Xi Jinping and the resulting "truce" on trade tariffs, helped produce a positive November return for global stocks, led by emerging markets.

The commodity complex suffered as oil prices plunged from $76/barrel (reached in early October) to the mid-$40/barrel range. Some commentators attributed the sharp sell-off in oil prices to technical selling pressures from hedge funds that systematically had a leveraged carry trade in place (long oil / short natural gas), but the sell-off in oil was not entirely due to technical reasons as global supply (North American shale production, easing of Iran sanctions) had finally caught up with demand.

In December, what started as a lingering concern over the impact from U.S./China trade disputes accelerated into a larger concern over Federal Reserve tightening and its impact on global economies. A combination of "over-tightening" by the Fed and continuing signs of an industrial slowdown in China led to a 7% sell-off in global equities as measured by the MSCI All-Country World Index (ACWI). S&P GSCI Industrial Commodities dropped 7.75% as the 1-month spot generic oil price plummeted to $45.41/barrel.

Investor sentiment towards cyclical risk assets soured throughout the quarter, from global equities to commodities and credit spreads. The global macro environment has also deteriorated with many manufacturing surveys indicating slowdown and/or contraction and tightening financial conditions reflected by widening credit spreads.

The December sell-off was largely "beta-driven" as investors fled to defensive sectors. Defensive sectors such as S&P Utilities, Telecom, and Real Estate (-4.0%, -7.3%, -7.4% respectively) outperformed the S&P 500 (-9%). MSCI Minimum Volatility returned -7.1%, outperforming the other major factor indices. S&P GSCI Precious Metals rose 5.2%, indicating a strong preference for gold as a safe haven asset. U.S. Small Caps and Value underperformed Large Caps and Growth, respectively.

By year-end, the 10-Year U.S. Treasury Yield dropped to 2.68%, down from 3.14% at the end of October, helping contribute to a 1.8% return in the U.S. Bloomberg/Barclays Aggregate Bond Index. Credit spreads widened as U.S. Bloomberg/Barclays US High Yield Index dropped 2.1%. Rather than responding positively to dovish Fed comments following the December meeting and a possible détente in the U.S. / China trade conflict, credit markets appear to be pricing in a more adverse economic backdrop for risk assets.

However, one notable bright spot is the outperformance of emerging markets over developed markets, possibly indicating that a valuation floor has been reached. MSCI EM was only down 2.7% versus -9% for the S&P 500 and -4.9% for MSCI EAFE.

See the final section ("3D Asset Management 4Q and Year-to-Date 2018 Charts and Exhibits") for 4Q2018 and YTD 2018 global asset class performance, as well as key market and macroeconomic time series.

2019: The Path Less Certain

Regardless of how the 2019 macro landscape unfolds, trying to predict how investments will behave during a specific macroeconomic regime remains a challenge. One thing has become clear: there is a disconnect has between the angst signaled by the financial markets versus positive U.S. economic data and the Fed's economic outlook for 2019. And market sentiment is spilling over into corporate sentiment, as "nearly half of chief financial officers believe a recession will start within a year and 80% think a recession will hit by the end of 2020, according to a Duke University Survey."

Our beginning-year call of late cycle beneficiaries (value, small caps, hard assets such as commodities) ended up producing laggards for much of 2018; although our cautious outlook on emerging market performance (after its torrent 2017 run) proved to be more prescient. We had also been cautious throughout the year on narrowing credit risk premiums signaling excess investor exuberance and questionable debt underwriting resulting in fewer creditor protections. In hindsight, we weren't cautious enough, as we still viewed the macro environment as supportive of credit risk-taking even though we felt risk premiums had narrowed to overly rich levels.

Early in the year, we also wrote that markets were getting ahead of themselves despite strong U.S. earnings growth benefiting from U.S. fiscal tailwinds of lower corporate taxes and regulatory relief. After a strong January run, we expected "total returns for 2018 will comprise mostly of earnings / cash flow growth rather than further narrowing of risk premiums (i.e. rising asset valuations)." We correctly anticipated that U.S. market valuations had reached a peak in January, but did not anticipate the magnitude of earnings multiple contraction that occurred at the end of the year (Figure 3).

Figure 3 - World Equity Markets Trade at or Below 10-Year Median Forward Price/Earnings Valuations

We believe over the long run that earnings growth (or lack of) primarily determines market advances (declines); and that the valuations investors are willing to pay for earnings growth reflect a level of confidence (or uncertainty) in the factors influencing future earnings growth. The U.S. has been trading at a premium to other regional markets primarily due to U.S. companies generating stronger earnings growth and profitability relative to their cost of capital versus other regions that have suffered from lower growth and profitability.

However, not even the U.S. is immune from negative sentiment that is showing up in declining earnings estimates heading into 2019 (Figure 4). The 12/21/2018 edition of FactSet Earnings Insight reports that the consensus outlook for 2019 S&P companies is for earnings to grow 7.9% on top of revenue growth of 5.3%. Although still positive, this is a marked deceleration from 10%+ growth that was expected at the end of September, and the S&P is vulnerable to further disappointments depending on company guidance following Q4 2018 earnings releases.

Figure 4 - Expected S&P 500 Earnings Growth for 2019 on the Wane (Catching Up with the Decline Seen Across the Rest of the World)

Source: Bloomberg as of 12/31/2018 using Bloomberg 12-Month Earnings Estimates.

The path for U.S. earnings growth looks less certain, and less certainty typically results in a higher risk premium demanded by investors. Hence, we would expect U.S. stocks to track earnings growth, but would not expect a higher valuation paid for that earnings growth. Throughout the year we also witnessed market anxiety over the Fed falling behind the inflationary curve ($70/barrel oil prices, 3.25% 10-Year U.S. Treasury Yields) to the Fed overshooting on rate hikes effectively ending the late cycle and pushing the U.S. economy into recession. The bond market will likely give the first sign of a recovery as the "safety" bid for safe U.S. Treasuries reverses itself.

Growth momentum stocks (i.e. the FAANGs) may continue to enjoy premium valuations in an environment of scarce growth, but overall valuations for equity and fixed income credit risk are more attractive following the steep 4Q2018 sell-off. However, even if headline news at the margin becomes more positive (i.e., progress on U.S./China trade discussions, a more dovish Fed, commodity price recovery), we would not necessarily expect valuations (high price/earnings multiples, narrow credit spreads) to return to their early 2018 peak levels. As attractive as "value" and "size" or small-cap risk premiums have become, these risk factors may continue to lag the broader market until some clarity is restored on fiscal/monetary policies as well as the broader economic outlook. A continued decline in long-term interest rates should also benefit growth stocks over value stocks.

The risk regime that characterized low market volatility and complacency throughout 2017 and early 2018 has shifted to one of greater uncertainty; and expectations of more turbulence ahead as the market waits on bated breath as to whether this long, extended cycle will fall into recession. In Let's Talk Turkey, we discussed how risk-based valuations in equity and credit incorporate the more realistic and uncertain outlook facing investors, but that such risk premiums reflect more attractive entry points for longer-term investors.

Market pricing may push risk premiums into extreme complacency or fear over the short-run, but current market prices reflect a more balanced view of risk and reward. As we wrap up our year-end commentary and market outlook, the following are some positive points to suggest that 2019 won't look as bad as implied by current market volatility. The big negative risks (Fed overshoot, China slowdown, corporate leverage, D.C. headlines) are largely known at this point, so we won't rehash those.

  • The strength of emerging market performance relative to developed markets throughout 4Q2018. The fact that emerging markets are recovering some of the ground lost during the first half of the year might indicate that fears of systemic financial meltdowns may be overblown. Lower commodity prices and a Fed "pause" should prove to be beneficiary tailwinds for emerging markets heading into 2019.
  • Credit rating agency forecasts for lower default rates in 2019. A cynic might treat rating agency default forecasts with a grain of salt given the poor track record of rating agencies' abilities to forecast credit downturns (well after having been priced into the credit markets). However, rating agency outlooks matter when viewed in the context of dynamic interactions between rating agencies and corporate borrowers (i.e., credit analysts may be more flexible with company management in a low default environment). Highly leveraged companies may prioritize the interests of creditors over shareholders now that credit markets are not as receptive as they had been the last couple of years.
  • Some form of agreements reached on U.S./China trade discussions and BREXIT negotiations. Combined with a U.S. economic backdrop benefiting from strong employment and consumption and fiscal tailwinds, such positive news should affirm that the outlook is not as grim as what is being priced into the markets.
  • A data-driven Federal Reserve. Future Fed communications should acknowledge current market weakness and warning signals generated by the credit markets when setting expectations for future rate hikes and balance sheet changes. The Fed may exercise more "patience" when setting policy in anticipation of "inflationary pressures" building up in the economy.

4Q and Year-to-Date 2018 Charts and Exhibits

This section provides charts and exhibits covering market performance and macroeconomic conditions. All data comes from Bloomberg unless noted otherwise.

QTD Ending 12/31/2018

YTD Ending 12/31/2018

Notable Market and Macroeconomic Time Series

U.S. Fixed Income Credit Spreads

U.S. Term Structure and Inflation Expectations (Long-Term TIPs vs. Nominal Treasury Yields)

Trade-Weighted U.S. Dollar Spot (DXY) and U.S. Dollar Against Yen and Euro

S&P 500 Trailing 12-Month Sales Growth and Operating Margins

Global Manufacturing Sentiment

German and Japanese Business Sentiment

European and Asia-ex-Japan Financial Conditions

U.S. Business Sentiment

U.S. Financial Conditions

Global Oil Supply and Demand

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