There are things to watch out for as an investor because even if you’re Warren Buffett, it is impossible to know what will happen in the markets. But you don’t need a crystal ball to see that the investment terrain in 2019 will be dominated by lower global growth, geopolitical friction, and Central Bank tightening, not to mention all the political uncertainty stemming from the White House. This tough macroeconomic environment will amplify volatility as data surprises emerge.
Speed bumps lie ahead for investors. It is too early to pull back on risk taking, as the backdrop still looks constructive, but caution is needed.
Here is my list of the top 10 things that investors should watch out for as we head into 2019.
1. U.S. and China friction intensifying
Trade tensions between the U.S. and China caused significant market volatility in 2018. For now, the 90-day truce shows signs of progress. China has already agreed to reduce auto tariffs and increase soybean imports. More concessions are likely. But direct trade concerns are a precursor to the bigger structural problems of China’s alleged intellectual property theft and cyber espionage that still pose threats to U.S. national security.
Implementing solutions to these knotty problems will extend well beyond the February 2019 deadline. With technology dominance core to China’s long term growth, it is unlikely to scale back. Negotiations will be difficult as the U.S., with support from allies, demands that China reign in its aggressive practices. Investors should expect more volatility if trade tensions between the U.S. and China flare up again.
2. U.S. investors are under pricing Fed moves
Investors are expecting only one rate hike next year, even though the Federal Reserve System of the Unites States (Fed) has indicated that it will make two hikes. With well-anchored inflation, strong employment, wage increases hitting 3% and reasonable growth, the economy can tolerate three hikes. The Fed has few reasons to pause in 2019, and investors will be surprised as barely one rate hike is priced into the markets.
3. U.S. equities still have an upside
U.S. equities quickly corrected over the last several months as investors assumed disappointing earnings next year. That seems overdone. Outside of a recession, equities tend to perform. While margins will feel the pinch from rising wages and rates, earnings-per-share are still expected to grow by 8% year-over-year. A modest improvement in trade relations with China would also go a long way to boosting investor sentiment. While market volatility will continue, we expect that U.S. equity markets still have room for growth in 2019.
4. China’s growth downshifts more quickly than expected
Recent Chinese data has disappointed investors. Retail sales hit a 15-year low, industrial production dipped to a 3-year low, and auto and home sales are softening, even as China stimulates its economy with tax cuts.
It is also worth noting that China has already seen windfalls from accelerated exports ahead of U.S. tariffs, and has benefited from currency depreciation that helped take the early edge off the slowdown. Assuming U.S. trade tension continues well into next year (see #1), China may have fewer dials left to stoke economic growth. For investors, some data surprises lie ahead.
5. The U.S. dollar stays strong
A continued hawkish Federal Reserve will keep the dollar strong, but close to peak. Other developed and major emerging market economies are in less of a rush to hike rates. As the Trump Administration renegotiates major U.S. trade agreements, non-U.S. central bankers are concerned about growth impacts, and are holding back on policy moves. While a strong dollar benefits consumers, it does pinch corporate profits as exports become less competitive, taking a toll on earnings.
6. Organization of Petroleum Exporting Countries (OPEC) won’t be blindsided again.
In advance of Iranian sanctions, President Trump requested that Saudi Arabia expand its oil supply to offset Iranian cuts. It obliged, but at the last minute, Trump allowed eight countries to import Iranian oil. This oversupply quickly drove a price drop. To rebalance, OPEC and Russia agreed to supply cuts which should lift the price of Brent oil back to US$80 per barrel next year.
7. U.S. yield-curve inversion is flashing yellow, not red.
Yield-curve inversions grab headlines as an precursor to recessions. However, the most robust inversion measure, the 10-year to 3-month Treasury spread, is still positive. If it turns negative or inverts, the average lead time to a recession is 17 months, within a range of 7 to 33 months. When combined with two other measures, namely leading economic indicators and the Fed becoming restrictive, the predictive power greatly improves.
Right now, the composite signal is not suggesting a 2019 U.S. downturn – notwithstanding a severe geopolitical shock.
8. Emerging Market equities and a bet on a trade truce.
Any improvement in U.S.-China trade tension and the ability to work together would lift trade sentiment. Emerging market (EM) equities in particular would benefit given their battered valuations, as a lot of bad news has already been priced in. EM flows have recently picked up as investors see opportunity. However, volatility will remain high until some harder evidence of a trade truce emerges. Waiting for a stronger signal before buying seems prudent.
9. Corporate bond defaults
Corporate fundamentals for investment grade bonds are solid. The earnings outlook remains healthy, interest rate coverage ratios are strong, downgrades currently are tame and defaults benign. Investor demand for Investment Grade (IG) bonds remains buoyant, and while spreads have increased recently, they are still below long-term averages.
However, in a mature credit cycle, investors need to be hyper-diligent in bond selection. Maintaining an up in quality bias through placing a premium on companies with strong free cash flow is a good first step.
10. Twitter missives won’t impact policy
President Trump has two prominent targets: interest rates and oil. With assertive tweets, he urged the Fed to hold back on rate increases. He also blasted Saudi Arabia to oversupply and bring down oil prices. Neither has obliged. The Fed is conscious of maintaining its independence, while Saudi Arabia, alongside other OPEC partners and Russia, focuses on stable oil prices that support domestic fiscal budgets. Neither is likely to change. Investors should not to get too distracted by noise coming out of the White House that is unlikely to drive real change in market fundamentals.