With the recent increase in market instability, we have been working diligently to analyze it all and define the path to set for the future. So, we want to take the time to briefly share our views with the hope that we can provide some consolation and guidance as we begin the New Year.

We’ve heard from several clients telling us that they’re becoming concerned with the volatility, and that they’re afraid that we may be seeing the early signs of another financial crisis. Unfortunately, this correction is reminding us that in the face of uncertainty and economic change, markets can fall. We understand the fears. But while 2008 certainly was a very difficult time to be invested in the capital markets, we think we’re a long way from the factors that would lead to another financial crisis. We’re confident that to be successful in this environment, just as in 2008, we must hold back the emotional impulses and make informed, rational investment decisions to prepare for the next phase of the market cycle.

ECONOMY AND MARKETS SEEM DISCONNECTED

Despite market unsteadiness, in our view the U.S. economy appears to be fundamentally solid. There’s a certain amount of debate going on in the markets as to whether we’re simply experiencing a growth scare, or an actual shift in the economic cycle which could indicate a recession. We believe that for the most part, man-made events (not conventional economic cycle influences) are the source of the current market challenges, creating an uncharacteristic “disconnect” between the economic fundamentals and the markets.

In the economy, the manufacturing and service sectors are both growing. December numbers for business activity did show some weakening from earlier months, however we are still expanding the economy. In addition, employment is high, and inflation is tame. Interest rates, while rising from recent levels, are still low on a real basis. While we do expect to see some weakening in the economic numbers in 2019, current data does not indicate a high likelihood of a recession in the year.

Though we may have already hit the peak growth rate, we do expect a continuation of economic growth as we transition into the late phase of the economic cycle where the pace of growth moderates. Our expectation is for U.S. growth on the order of 3.25% overall in 2019. As for the global economy, we expect it to slow slightly, to about the 3.0% – 3.25% range for 2019.

Meanwhile, corporate profitability is robust. While the numbers for calendar year 2018 are not yet in (pending  results for the fourth calendar quarter), we expect the S&P 500 to have delivered approximately 18.0 – 20.0% overall earnings growth in 2018, boosted by the passage of the tax reform package. This would be the best performance for earnings since 2010. Looking into 2019, we expect earnings to continue to grow in the range of 7.0% – 9.0%.

SO WHY ARE MARKETS SHOWING INCREASED VOLATILITY?

To be sure, we currently have an abundance of catalysts contributing to volatility. Some of the issues we’re currently focused on include:

  • the Fed raising the overnight lending rate while simultaneously unwinding the quantitative easing program
  • a trade war and restructuring of the global trade structure
  • growth of the federal deficit
  • a messy exit of Britain from the European Union
  • geopolitical uncertainties
  • concern about future economic growth
  • oil prices are all over the map
  • China’s slowing economy

Whether or not these issues are likely to overcome the strength of the economy is debatable. Indeed, we expect some of these issues to endure through 2019. Any one alone could lead to continued market volatility. For our part however, we don’t think the economy will be overpowered by these issues in the next year.

Specifically, the issues of trade policy and the Fed, and their impact on the economy are issues that concern us. Trade policy has the greatest potential to disrupt the growth of both the U.S. and global economies over an extended period.

As for the Fed, we are wary that excessive rate increases could impact the outlook. History shows that the Fed has over-tightened to the detriment of the economy repeatedly. But, given the current expectation for only two (or less) hikes in 2019, we are hopeful that they’ll be successful in engineering a “soft landing.”

SO WHAT SHOULD AN INVESTOR DO?

We believe it’s particularly important now to resist the impulse to let the unsettling, day-to-day headlines affect us, and to maintain a strong focus. In times like these, the central questions we need to be asking are:

  • Is the outlook for the economy positive or negative? (In essence, where are we in the cycle?)
  • Is the outlook for corporate profitability positive or negative?
  • Are assets attractively priced?
  • How could the known issues change these outlooks?

As stated above, we think we’re moving into the late stage of the economic expansion. Accordingly, we’re watchful for indications of a recession appearing on the horizon, though we do not currently see that for 2019.

For as long as the modern financial markets have been in place, the primary driver of asset prices has been the ability of publicly traded companies to generate profits (also known as “earnings”). Furthermore, asset prices tend to change based on the outlook for future earnings, not what has happened in the past. We see earnings continuing to exhibit growth in 2019.

In terms of the attractiveness of the major markets, currently the S&P 500 is priced at a valuation (price/earnings ratio) of approximately 14.2 times expected 2019 earnings. This is below both the five and ten year averages. While it is certainly possible that valuations go lower, we see equities as rather attractively priced, and would be buyers rather than sellers at these levels. We think that before we see a sustained move higher in the equity markets, we’ll experience a continued sideways move that is punctuated by bouts of both upside and downside volatility through some point in early 2019. We do think that 2019 has the potential to provide a meaningful rebound, resulting in attractive returns from stocks and bonds. For that reason, we think that it will be prudent to put new money to work during this period.

We view the path forward as being one characterized by patience, taking advantage of attractive opportunities to build positions and maintaining a close watch on economic indicators for hints that the economy has shifted from our outlook.

Of course, if you have any questions or concerns, please feel free to contact your Atlas Wealth Management Advisor to discuss your specific situation with you.

 

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