2019 – Elephants in the Room


By David Nelson, CFA

On the heels of a wild and very dangerous December investors are wondering if this is what we can expect in 2019 or is the worst over and we start rebuilding from here? The final trading days of the month gave investors some relief and while we welcome the rally, there’s obviously a lot more work to do. We can point to all the usual suspects including the Fed, Washington, trade, falling oil and computerized trading but in the end all of the above played a roll.

Anyone who studies finance knows there are two sides of a balance sheet – Assets and Liabilities. To be sure today’s markets have their share of liabilities or concerns so let’s explore the two biggest.

Fed logoMost of my readers know I’ve been critical of the Fed but make no mistake I’m aware just how difficult the job is and the dedication these professionals put into their work. In some ways it’s an almost impossible job. Regulating the U.S. economy is like trying to steer a battleship. Policy they put in place today can take months, even a year to wash through the system. I suspect the Fed was spooked by hot employment numbers and above trend GDP reports early in the year. Moving into high gear the Fed picked up the pace with a hawkish policy and rhetoric to match.

This is where I part company with the FOMC. They are working from a mindset that the United States is incapable of sustaining anything above 2% GDP growth. The whole idea of making the U.S. more competitive with a corporate tax rate in line with our trading partners was to break away from sub-par growth. It’s not a lock that we could do it but there’s no way it can happen if the Fed slams on the breaks every time the economy picks up speed. With inflation still under control the Fed can well afford to pause on rate hikes. As for the balance sheet I get it. At over $4Trillion it’s important for them to continue to let the balance sheet roll off but I suspect it will have to be at a pace slower than expected. With nothing in history they can point to the Fed would be well advised to proceed with caution.

U.S. Yield Curve 

When you think about it, quantitative tightening started all the way back in May 2013 when the Fed announced its tapering program in Congressional testimony. Coming from near zero the Fed started raising rates in late 2015 and picked up speed once current Fed Chair Jay Powell took the helm. On the heels of very strong employment and GDP reports the Fed continued to tighten with the last rate hike in December. At the same time starting in October last year the Fed started to let the balance sheet roll off no longer replacing maturing securities so in effect you were seeing the tightening process proceed on two fronts.

10 Year Yields

When rates on the long end of the curve started to break out to the upside institutional players including pensions and insurance companies took the opportunity to de-risk moving from equity to fixed income. For the first time in a decade they could fund some of their future liabilities with bonds. These are institutions that often have a heavy weighting in fixed income but had been forced from the markets by a Fed that kept rates near zero.

Markets of course reacted violently and the most recent selloff began. With the wealth effect dissipating almost overnight bond yields reversed course pushing the yield curve dangerously close to inversion and the conversation about our economy suddenly switched from too hot to a potential recession. Already, some economists like Goldman’s Jan Hatzius have cut their growth forecast from 2.5% to just 2%.

The China Syndrome


The ongoing trade war with China has been at the top of the list for investors for most of 2018. Let’s define what victory looks like. China has historically out maneuvered the U.S. when it comes to trade for the last several decades. I think we all understand the importance of intellectual property.

Question: Can the administration broker a deal to get China to play by the rules and avoid economic chaos in the process? Easier said than done for any administration and likely part of the reason the last three made little progress. China understands all too well that the U.S. thinks in terms of an election cycle while they plan for decades. President Xi has the advantage effectively in office for life. While U.S. markets put in their worst performance in the last 10 years China came in dead last for the world’s major markets off (-33%) for 2018. In comparison price performance of the S&P 500 was (-6.24%) The administration has put out some positive statements regarding the current talks recently but I think most are skeptical having been disappointed several times before. Victory can only come if both parties can portray it as one and take it back to their respective countries as a win.

Turn it Upside Down

For the last couple of months we’ve devoted most of our thinking to what could go wrong and given stock performance understandable. Let’s turn that thinking upside down and focus on what could go right.

For starters the Fed got the memo. I don’t think it’s up for debate anymore. Even the Fed knows the last hike was a policy mistake because within 24 hours they trotted out NY Fed President Williams to walk back the harsh rhetoric and assure us they are listening to the message of the markets. That’s a huge plus going into the New Year. Unless inflation picks up dramatically I suspect we’ve seen our last hike for a while.

At some point a trade deal will happen. The status quo is unacceptable for everyone at the table. Despite what seems like a media blackout of good news, last week Bloomberg reported that China was cutting tariffs on 700 items. That smells like an olive branch being held out during the tense negotiations. It’s not just the United States anymore. China’s blatant theft of intellectual property is well documented and isn’t going to be tolerated by most of the developed world. As pointed out in these posts several times, it’s gone well beyond the industrial complex and has become outright espionage stealing even our most sensitive military secrets.

Stocks Follow Earnings

It’s not surprising that given recent stock performance estimates for 2019 and beyond have started to slip. Stocks for the most part follow earnings. The chart above tracks S&P 500 performance with earnings expected for the next 12 months. 2014 – 22015 is a good history lesson. Earnings stalled and not surprisingly U.S. markets pretty much went nowhere. Once earnings moved back onto I-95 North the bull market continued. For the moment estimate revisions seem stuck in neutral. We need to see that improve before stocks can move meaningfully higher.

How will we know the coast is clear?

Look, the post-Christmas rally was a welcome relief from deeply oversold levels but bottoms are a process. With the slope of most long term averages pointing down it will likely take months, certainly weeks to repair. An early indicator might not even come from stocks here in the U.S. Emerging markets were the first domino to fall and might in fact be the first to turn.

EEM Absolute Return
EEM nothing

While a price chart of Emerging Markets ETF (EEM) is nothing to write home about, on a relative basis it starts to look better. For the first time in a while EEM outperformed SPY. The beginning? Too soon to say but bears watching.

EEM vs SPY 4th Quarter

For the last few months, policy and rhetoric at the Fed has been the guiding force for U.S. markets. With the quarter and 2018 in the rearview mirror the focus will once again shift to earnings. As usual, banks will be the first test kicking off earnings season in a couple of weeks. How much damage has the yield curve done to net interest margins and loan growth will be key data points for investors. The best news for financials right now is that current valuations reflect the concern.

Later in the month big cap tech reports after a miserable showing last quarter when nearly every popular name disappointed. Apple (AAPL) is key in that much of the NASDAQ is part of the Apple food chain. Cloud names will be a big focus and here there is little room for disappointment with well above market valuations.

All in there’s a lot to digest and after a bruising quarter and year comparisons are being made to other dark periods in market history. During each of those episodes the challenges seemed insurmountable with sentiment low and fear high. Part science and art almost all styles of investing require rules and a game plan to successfully navigate the terrain. We’ve got both.

Alright, the holiday’s are over. “Back to Work”