Stocks rose for the fourth consecutive week, thecorporate earnings, with several high-profile banks reporting quarterly earnings. All together, earnings were better than feared, and more importantly, commentary from management teams about the outlook was positive. As a result, the financial services sector outperformed the broader market, finishing 6% higher1. Outside the U.S., news was more mixed. Markets reacted positively to Chinese efforts to stimulate the local economy and reports that China is willing to take steps to reduce its trade surplus with the U.S. in order to achieve a trade deal. In Europe, the Brexit drama continues. While the U.K. Parliament rejected the Prime Minister’s deal to leave the European Union, Theresa May survived the vote of no confidence. What happens next is uncertain, but investors are increasingly speculating about a second referendum, or an extension of the Brexit deadline. Summing up, the S&P 500 has now quickly recovered more than half of its losses since September’s peak. This, in our opinion, highlights December’s oversold conditions, but it also poses some risk that the path from here could be rockier than it’s been the last three weeks. Make sure that the mix of equities and bonds in your portfolio reflects your comfort with risk.
Our Quarterly Market Outlook
In 2018 investors witnessed higher volatility and lower returns, with declines in almost every asset class. This year we expect a positive environment for investors based on solid fundamentals and better valuations. However, the return of sustained market volatility is a reminder of the importance of a well-diversified portfolio with appropriate allocations across all asset classes to help reduce the risk of lower portfolio returns in the late stages of the bull market.
- We expect the pace of economic growth to slow modestly in 2019 due to the waning effects of the tax cuts, which boosted GDP growth last year and the slowdown in interest-rate sensitive sectors like housing and autos. That said, we still view a recession in 2019 as unlikely given optimistic consumers, healthy job growth, and solid business investment.
- The U.S. unemployment rate continues to hover near a 50-year low, and we expect it to move slightly lower this year due to surprisingly strong job growth in the 10th year of this expansion. Historically, the unemployment rate increased an average of nearly 0.5% before a recession began, and thus current employment conditions suggest a continuation of economic growth. Moreover, over the past four years the household savings rate has averaged 6.8%, compared with 3.6% from 2004 to 2007, which suggests that consumers have a financial buffer available to support continued household spending (two-thirds of GDP). Faster wage growth and lower gasoline prices should also add to consumer pocketbooks and spending overall1.
- This economic expansion is the second largest on record, and while age is just a number, we expect more modest growth ahead consistent with the latter phase of the economic cycle. As markets have adjusted to slower growth and higher volatility, their expectations have become overly pessimistic, in our view. It’s worth noting that historically the final two years of an economic expansion have generated market returns of nearly 9%2.
- In 2018, the S&P fell by 6.2%, while earnings increased more than 20%, leading to the most attractive valuations of large-cap stocks since 2013.1 We expect earnings for large-cap stocks to increase 7% to 8% in 2019, a slower pace than last year, but above the historical average. In addition, large-cap stocks typically have had above-average returns following years when they’ve declined as earnings rose.
- Last year investors saw small- and mid-cap companies enter bear markets, with stock prices down 22% and 27%, respectively, at their Dec. 24 lows1. Improved valuations relative to large-cap stocks and our expectations of rising earnings make small-cap stocks an attractive opportunity to improve portfolio diversification, in our view.
Fixed Income Outlook
- In 2018, bonds outperformed stocks due to a drop in share prices late last year. Bonds play a role in stabilizing portfolio returns when markets are volatile. That said, we remain cautious on long-term bonds due to our expectation for rising interest rates, and we recommend that they represent no more than 15% of fixed-income portfolios. We also recommend owning a combination of bonds across intermediate- and short-term maturities, which historically has provided higher returns and steadier income than short-term fixed income alone.
- A key source of market volatility is investor concern that the Federal Reserve will raise short-term rates too much and curtail economic growth in order to slow inflation. Though this is a risk, inflation remains near the Fed target of 2%. Therefore we expect the Fed to be flexible and responsive to economic conditions and to likely pause rate increases over the course of the year.
- Our outlook calls for slower global growth this year, but we think a global recession is not yet imminent. In our view, investor sentiment is overly pessimistic, since the underlying fundamentals of global economic and earnings growth remain solid, if slower. While the Fed is increasing interest rates, foreign rates remain low, and monetary policies are still boosting growth in Europe and Japan. Additionally, low unemployment rates and rising profit margins are likely to accelerate earnings growth internationally, in contrast to decelerating S&P 500 earnings. China is also ramping up stimulus to soften its slowdown. Thus we believe international equities are poised to perform better this year.
- Trade is an important part of global growth, and uncertainty surrounding trade negotiations was a key source of market volatility in 2018. The U.S. entered 2019 with some resolution to trade conflicts, including a proposed trade agreement with Canada and Mexico as well as progress in trade talks with China. Despite some bumpiness ahead, we expect ongoing negotiations to lead to updated trade agreements and the easing of restrictions between the U.S. and its major trading partners.
- International markets and economic conditions appear to be further from the end of the cycle than the U.S., and equity valuations are more attractive, supporting our recommendation for an above-average allocation to international equity investments.
Late last year stocks become more volatile as investors reacted to a slew of concerns, including increasing interest rates, slower global growth, and trade tensions. We don’t expect these worries to quickly disappear in 2019, and therefore we think normal volatility will continue. However, stocks have bounced back sharply from their lows and reenergized the bull market, rising 13.5% in the first three weeks of the year1. Our optimistic investment outlook for 2019 is based on our expectation for continued earnings and economic growth, albeit at a slower pace.
By working with a financial advisor, you can prepare for a rising but rockier road in equities this year. First, keep realistic expectations for returns in this latter stage of the bull market. Second, make sure that the mix of equities and bonds in your portfolio reflects your comfort with risk. Finally, with stocks no longer expensive, use dips in the market to add high-quality investments at lower prices. Keep a broad perspective and focus on what’s important to you, and your financial advisor can guide you towards your goals by helping you navigate the road ahead.