In recent weeks, the stock market has been rattled by multiple forces, including new twists in the U.S. – China trade conflict, concerns over global growth, potential for a “hard” Brexit and developments tied to the Mueller investigation. Amid this swirling storm, the S&P 500 lost 4.6% last week. Although the index regained some of that ground through Wednesday, we anticipate that volatility will continue.
Risks in Many Directions
Front-and-center in the market turmoil has been last week’s arrest, at the request of the U.S. government, of Meng Wanzhou, the CFO of Chinese telecom giant Huawei, due to alleged violations of American sanctions against Iran. Wanzhou is a high-profile executive at a dominant company, and the timing of the move was particularly jarring given that the presidents of the U.S. and China had just agreed to a 90-day truce on tariffs in order to continue negotiating.
Another trigger was the inversion of the yield curve between two- and five-year Treasuries as investors lowered long-term interest rate forecasts based on expectations for slower growth. The news came on top of slower U.S. hiring, as well as renewed uncertainty about Brexit. Yield inversion has traditionally been seen as an indicator of pending recession; however, we believe it is less useful today as long yields are set by global growth and inflation. Even so, investors typically lend more credence to the three-month/10-year yield relationship, and that slope remains positive. Even there, the typical lag from inversion to recession has been about a year.
Exerting a subtler influence were court filings tied to campaign finance, collusion and obstruction, which have contributed to a narrative of a U.S. presidency under siege, especially in light of the changing leadership in the House of Representatives next year.
All of these specific hits to market confidence came at a time when investors were already questioning the longevity of the current, long economic recovery and worrying that earnings growth had peaked.
Silver Linings
Despite these seemingly off-putting developments, however, we see reasons to be constructive. Business fundamentals remain solid. The U.S. ISM manufacturing survey gained ground in November over the previous month; employment generally remains strong; and consumer confidence is elevated. Yes, much of the positive effects from the Trump corporate tax cuts have already flowed through to earnings and valuations, and some companies are being affected by tariffs. Still, we believe earnings can expand in 2019, albeit at a slower pace than in 2018, which would suggest that we may not be in the recessionary environment that investors seem to be fearing.
Moreover, we would point to several specific developments as improving the potential backdrop for risk assets:
- The Federal Reserve has moved from forward guidance of steady rate hikes to a stance that’s data-dependent, perhaps in light of more volatile market conditions and weakness overseas. The bond market now anticipates another rate hike in December and just one for all of 2019 (the latter down from three just a few weeks ago). This means that the interest rate headwind seen for the past year could be downgraded to a mere breeze.
- Despite the Wanzhou incident, the U.S. – China truce may actually produce positive results. China has already said it would cut tariffs on imports of U.S. cars, and purchases of other goods and services may be on the table. Thus far, the parties seem to be trying to keep commerce separate from law enforcement and the allegations against Wanzhou.
- After seeing oil prices fall below $50, OPEC and Russia agreed last week to curb production by some 1.2 million barrels per day. This could bring pricing discipline/stability back into that market and keep prices above uneconomic levels that could threaten profits in the sector.
All this suggests a more balanced economic picture than one might gather from recent downdrafts. After 10 years of gains, U.S. stocks really haven’t fallen that far from record highs. Markets and economies are cyclical by nature, and the Fed’s purpose has been to cool the inflationary jets before they overheat—something that it appears on the road to accomplishing. On balance, we believe that the economic expansion has room to run, which could bring a commensurate stability in stocks. Still, the timing of a more serious correction or even a bear market remains uncertain.
Using Asset Allocation to Your Advantage
With this in mind, we think that recent volatility provides investors with an opportunity to reappraise their tolerance for risk and reaffirm their investment goals. All of us want the stock market gains that have come most of the time (71% of years since 1929), but severe downdrafts can feel terrible to everyone, and can have real-life consequences for those who may need those assets before markets have a chance to recover.
So, once again it is a good time to check in with the broad outline of your portfolio in light of your objectives and time horizon, and consider making adjustments to allocations where investment positions may be a poor fit. In addition, it may be prudent to look for tactical tilts to capitalize on short-term market opportunities. In this environment, this may include seeking relative value opportunities to maintain equity exposure while trimming positions with substantial gains. That said, we would argue that bailing on stocks out of fear should never be a primary driver of change; nor should misguided attempts to time markets.
We believe a better approach is to understand the process of establishing and implementing long-term investment goals and an asset allocation framework, and to stick to your guns—assuming there hasn’t been a change to your long-term investment goals or asset allocation framework and your investments jibe with your goals (e.g., income and future capital appreciation) and risk tolerance. In fact, if you are able to tame your anxiety, a potentially beneficial risk-response mechanism when there are dark days would be to capitalize on the fear of others. In such cases, you can see price declines as an opportunity—to add or increase exposures to assets with the potential to grow your wealth over time.
