Earnings were the primary determinant of 2018 stock market performance, and it’s easy to extrapolate that to 2019, but we think liquidity will be the driving factor next year.
- We expect recent market weakness could continue, with stocks testing a low before rallying higher.
- We also believe markets have become too pessimistic on 2019 earnings growth.
- A step down in growth is to be expected given the front-loaded aspects of the 2017 tax cuts.
- Interest rates will continue to climb, though at a somewhat subdued rate, while the Fed will also continue to shrink its balance sheet. Therefore, liquidity will continue to tighten and will remain a key variable to monitor.
- We expect strong cash flows and strong buybacks to support stocks and for quality-oriented stocks to outperform in 2019.
Key Driver in 2019
We think liquidity will be the driving factor next year. We look at liquidity in several ways. The strength of the U.S. dollar is one. The U.S. dollar continues to surge, and that’s a negative for liquidity. The nominal change in interest rates, which continue to rise as the Fed tightens monetary policy, also impacts liquidity. Perhaps the most important liquidity driver is credit spreads, which determine the cost of borrowing for consumers and businesses. Although spreads have only widened modestly recently, the biggest potential risk in 2019 is a curtailment of liquidity that creates the next bear market.
A widening of spreads should have the effect of separating leveraged companies from those with less leverage. Spread widening should be positive for active management. As we get later in the economic cycle and spreads start to widen, some companies become more sensitive to market drawdowns or weakness. In some cases, you have perfectly good companies with high leverage and fine coverage ratios, but they’ll get caught up in a basket of so-called highly leveraged stocks and decline just as much as others. That can create opportunities for active managers to differentiate a quality company with a smarter debt structure that might get sold off indiscriminately.
The return of a more normalized volatility environment, which has been sparked by an increase in Treasury yields and the term premium for bonds, increased worries about China and some high-level earnings disappointments, also creates more opportunities for active investors to make changes. Periods of volatility allow us to ask very productive questions about the stocks we own and whether they should be let go, or if valuations have become attractive enough to warrant buying a stock that we have been researching for some time. A rise in the CBOE Volatility Index (or VIX) has historically trailed the flattening of the yield curve by 18 months, meaning we should expect more volatility ahead.
Volatility Picks Up Following a Flattening Yield Curve
Impact of The Political Cycle
The year following midterm elections has historically been positive for equities, with the S&P 500 up an average of 15.3% in the 12 months following midterms going back to 1950. Post-midterm election environments are also positively skewed due to the presidential cycle.
This phenomenon, which closely mirrors the economic cycle, shows that the economy has not seen the start of a recession during the third year of a presidential term in the modern era due to the nature of fiscal stimulus. Specifically, fiscal spending tends to be strongest during the middle of a presidential cycle. For example, consumers will see a $60 billion boost in spending potential in 2019 from tax refunds that reflect the reduced tax rates from the late 2017 tax reform. We could also see additional stimulus as a result of a divided Congress that may not agree on much but could come to a compromise that leads to higher infrastructure spending.
Post-Midterm Election Performance
Sector Opportunity: Biotech
The outcome of the midterm elections should create opportunities within specific sectors or sub sectors. The health care sector has arguably the most to gain or lose. A congressional split takes drug price controls largely out of the near-term discussion. This should be viewed as positive for pharmaceutical and biotech stocks. Biotech is an interesting long-term opportunity. These stocks have not acted defensively despite what we believe are very reasonable valuations that have gotten cheaper along the way. Yet we find the sector to be among the most attractive across the market. Many biotech companies don’t have many financing needs and have good balance sheets. They could also be attractive acquisition candidates for larger pharmaceutical companies flush with repatriated overseas cash.
The Limits of U.S. Growth
An Extended Business Cycle
Liquidity is the Question
A Plethora of Risks
Current Volatility, Long-Term Opportunity
Choppy Markets Ahead
Time to Get Defensive?
Royce & Associates
A Shift Toward Cyclicals
Focus on Growth
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
A coverage ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Leverage refers to the amount of debt held by a company or sector of the market. Gross Leverage refers to total debt divided by the last 12 months (LTM) earnings before interest, taxes, depreciation and amortization. Net leverage is net debt (total debt minus the value of cash and other similar liquid assets) divided by the last 12 months (LTM) earnings before interest, taxes, depreciation and amortization.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
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U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
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