2019 U.S. Market Outlook: Ten Years Gone
Putting more meat on the bones of my portion of our outlook summary released last week.
When it comes to the relationship between economic data and the stock market, “better or worse tends to matter more than good or bad.”
Bear markets and recessions are difficult to time accurately, but there are tried-and-true disciplines investors can adopt to weather any coming storms.
Early last week we published our collective 2019 outlook summary and today’s report will put some more visual meat on the bones of that summary.
We’ve been having fun with cartoons over the past few years; all created by Schwab’s talented graphics guru Charlos Gary. Mine for the outlook summary attempted to have fun with the notion that some of the factors which have kept animal spirits in high form over the past couple of years are fading or have left the building altogether.
We have been in a unique era over the past couple of years with a yawning gap between so-called “soft” economic data (survey/confidence-based) and “hard” economic data (actual measures of growth/activity); with the former lifted by both business and consumer confidence. It’s this confidence that’s now being tested, courtesy of the trade war, tighter financial conditions, domestic/global political upheaval, and slowing global growth (among others). You can see a chart of financial conditions below; which you’ll note have been tightening sharply since the beginning of 2018 (decidedly different from the loosening that occurred during the first two years of the Fed’s rate hike cycle, which began in late-2015).
Rapidly Tightening Financial Conditions
Source: Charles Schwab, Bloomberg, as of December 14, 2018. An increase in the Goldman Sachs U.S. Financial Conditions Index indicates tightening of financial conditions and a decrease indicates easing.
Better or worse…
Most of the deterioration in U.S. economic data has been subtle and/or somewhat under the surface. But as I always like to highlight—especially at possible inflection points in the cycle—when it comes to the relationship between economic data and the stock market, “better or worse tends to matter more than good or bad.” Assuming a recession does not begin until after next July, at that point, this expansion will be 10 years, and the longest in the post WWII-era.
Leading U.S. economic indicators continue to rise (as of this writing, which pre-dates this coming Thursday’s release of The Conference Board’s Leading Economic Index); but there has been notable “second derivative” (rate of change) deterioration in a few key leading sub-indicators. These include the stock market, building permits, the average workweek, the yield spread and unemployment claims (notwithstanding last week’s recovery).
Yield curve as recession/bear market indicator
Much ink has been spilled on the yield curve over the past couple of weeks—especially when the “belly” of the curve (5-year minus 2-year Treasury spread) inverted recently. Although this has served as a leading indicator of sorts for the more common yield curves, the near-panic that inversion induced was probably a bit overdone.
Below is the yield curve that’s proven to be most relevant to the stock market. It’s the spread between the 10-year and 3-month Treasury yields, and as you can see, it recently flattened to less than 50 basis points. The gray bars represent recessions, while the red bars represent bear markets; so perhaps you can see why a shift down toward inversion causes consternation. However, although all of the yellow-circled inversions were ultimately followed by both bear markets and recessions, the lead time was variable (and often long).
Although the median span between inversions and bear markets over the past half-century has been 0 months, the range around that median was -5 months to +24 months. The median span between inversions and recession starts was 12 months, with a range of +5 months to +16 months. Finally, the median decline for the S&P 500 during those bear markets was -36%, with a range of -20% to -57%. (I used medians instead of averages given the relatively few instances and the bias to the averages that came from the vagaries of the “double-dip” recession in the early-1980s.)
Yield Curve Not Yet Inverted
Source: Charles Schwab, Bloomberg, FactSet, as of December 14, 2018. Bear markets are S&P 500 declines of 20% or more. November 1978 inversion reflects November 1980 bear market and July 1981 recession starts.
There are myriad recession probability models out there, but one popular one, created by the New York Fed, uses the yield curve as a primary input. As you can see below, the probability is up, although still low at just under 16%. However, before dismissing it as a premature sign, do note that it was historically usually the case that once the model hit this point, it ultimately went on to accurately reflect a recession (exceptions were in the mid-1960s and mid-1990s).
Recession Probability Rising
Source: Charles Schwab, Federal Reserve Bank of New York, as of November 30, 2018. Model uses difference between 10-year and 3-month Treasury rates to calculate probability of a recession 12 months ahead.
Stock market as recession indicator
As mentioned earlier, the stock market is a leading economic indicator. I’ve received many questions from clients recently about the history of stock market returns heading into recessions. The chart below shows that the worst median returns for stocks historically came in the six months leading into recessions. As such, given the market’s weakness over the past three months, trends heading into 2019 could provide a bit of a “tell” regarding the length of runway between now and the next recession. Caveat: the ranges around these returns are wide, especially for the periods during recessions, so “buyer-of-chart” beware.
Post-WWII Recession Performance
Source: Charles Schwab, Bloomberg, National Bureau of Economic Research (NBER). 1945-2009.
Many are trying to time the next bear market (a never-easy task); but we’ve been arguing that a “stealth” or “rolling” bear market has actually been underway for nearly a year. As the global liquidity tide has been receding, there’s been a need for repricing of higher-risk asset classes; which is exactly what’s been happening. Although not a fully-inclusive list, we have seen a couple of burst bubbles in the crypto-currencies and the “short-vol” trades (which imploded in spectacular fashion last February); followed by bear markets in the FAANG stocks, emerging markets and of course, oil. Small cap stocks recently hit near-bear market territory; and even within the S&P 500, at the recent market lows, more than 50% of the index’s members were down at least 20% from their 52-week highs.
Also mentioned earlier was the trade war and ongoing uncertainty—at least until the 90-day deadline for negotiations between the United States and China is reached. There is a bevy of trade hardliners and economists who dismiss the impact of tariffs on growth; which may be a factual read at this stage given that the proposed tariffs are significantly more onerous than the already in-place tariffs. However, if the truce period comes and goes without an agreement, and the additional proposed tariffs on U.S. imports of Chinese goods are implemented, the hits to growth both here and globally will become meaningful, as you can see in the estimates below. (Of course, were a deal to be struck and the additional tariffs were suspended, this would likely be cheered by business leaders, consumers and the stock market.)
Full Roster of Tariffs Will Bite
Source: Organisation for Economic Co-operation and Development (OECD) Global Economic Outlook, November, 2018. (http://www.oecd.org/economy/outlook/Growth-has-peaked-amidst-escalating-risks-economic-outlook-presentation-11-2018.pdf).
Given consensus expectations for U.S. economic growth to slow back toward 2% trend growth in 2019, taking a full percentage point off that growth would be a big hit. In addition, the percentage point hit is just of the direct variety; with the indirect hits through the confidence/animal spirits channel could add up to a greater subtraction from U.S. growth. And global growth, which has already slowed meaningfully this year, would take an additional hit; while world trade would suffer the largest hit from baseline.
Unemployment rate historically low … good or “bad” thing?
There is plenty to cheer in the U.S. economy, with the labor market still healthy, albeit the tightest in decades. One of my themes throughout this year was that “Main Street” was likely to be happier than “Wall Street” for the first time since this bull market began. That theme could persist heading in 2019, especially if job growth remains healthy and the unemployment rate remains low. But in keeping with “better or worse matters more than good or bad” we have to keep an eye on unemployment for a possible inflection point.
The chart below compares the unemployment rate (blue line) with the natural rate of unemployment (green line) with the spread between the two represented by the maroon line. The latter is a Milton Friedman concept and represents the “steady state of ‘full’ employment,” which is the hypothetical unemployment rate consistent with aggregate production being at the “long run” level.
As you can see, it’s been about 20 months since the unemployment rate crossed below the natural rate; which has historically meant the recession countdown clock had already begun (with a historical spread between 21 months and 50 months).
Unemployment Rate Well Below Natural Rate
Source: Charles Schwab, Department of Labor, FactSet, U.S. Congressional Budget Office, as of November 30, 2018.
Earnings recessions vs. economic recessions
Although an economic recession is getting a lot of attention, an earnings recession is absent in the discussion. I am not yet out on a limb with a view that an earnings recession is coming, the deterioration in the rate of growth is undeniable. As you can see in the chart below, earnings are set to fall from a cycle-record growth rate of 28% in this year’s third quarter to only a bit above 5% for the first three quarters of 2019.
Earnings Growth Slowing Significantly in 2019
Source: Charles Schwab, Thomson Reuters I/B/E/S, as of December 14, 2018.
My concern as it relates to the expectations above is that next year’s forecasts don’t yet incorporate certain potential hits to the growth rate:
- If no trade deal is made between the United States and China and the full roster of tariffs kick in.
- Analysts have the highest growth forecasts for the energy sector vs. the remaining 10 S&P 500 sectors, and have yet to haircut those forecasts for the 2018 near-35% collapse in oil prices.
The last time we saw a collapse in oil prices (near-50% in late-2014 through late-2015), the hit to energy sector earnings almost singlehandedly took the S&P 500 into an earnings recession for four consecutive quarters beginning in 2015’s third quarter.
Even if we can avoid both an earnings and an economic recession, some enthusiasm curbing is in order as it relates to longer-term return expectations for U.S. stocks. Although households have not been big net buyers of stocks throughout this bull market, the appreciation in their existing equity holdings has been exceptionally strong (while they’ve done little rebalancing). As such, and as you can see in the chart below, households’ equity allocation is at a historically elevated level (matching the high prior to the 2007 stock market peak; and just below the all-time high near the market’s 2000 peak). For the somewhat obvious reason that a higher allocation means less cash available to power future moves higher in stocks, there has been a tight historical correlation between households’ equity allocation and subsequent 10-year stock market returns.
Households’ Stock Allocation Near-Record
Source: Charles Schwab, FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2018 (c) Ned Davis Research, Inc. All rights reserved.), as of September 30, 2018. Equity allocation (includes mutual funds and pension funds) is % of total equites, bonds and cash.
Although the aforementioned exposure by households to equities suggests a heightened behavioral measure of sentiment; attitudinal measures have been swinging more wildly—as will likely be the case heading into 2019. A move toward extreme pessimism could provide at least a short-term boost to the stock market (remember, at extremes, sentiment is often a contrarian indicator). Regardless, we continue to expect a higher plane of volatility—with the past couple of months possibly foreshadowing what’s to come next year.
Our emphasis to investors is to be highly disciplined and somewhat defensive, especially around strategic asset allocation, diversification and rebalancing. We will get another bear market and we will get another recession. Trying to time them perfectly is a bit of a fool’s errand, but there are tried-and-true disciplines that can help investors weather the storms.