IN BRIEF

  • The U.S. economy should slow but not stall in 2019 due to fading fiscal stimulus, higher interest rates and a lack of workers. Even as unemployment falls further, inflation should be relatively contained.
  • Central banks in the U.S. and abroad will tighten monetary policy in 2019 – this should continue to push yields higher. In the later stages of this cycle, investors may want to adopt a more conservative stance in their fixed income portfolios.
  • Higher rates should limit multiple expansion, leaving earnings as the main driver of U.S. equity returns. With earnings growth set to slow, and volatility expected to rise, investors may want to focus on sectors that have historically derived a greater share of their total return from dividends.
  • After a sharp fall in valuations in 2018, steady economic growth and less dollar strength may provide international equities some room to rebound in 2019. However, the climb will be bumpy and investors should ask themselves, in the short run, whether they have the right exposure within different regions and, in the long run, whether their exposure to international equities overall is adequate.
  • There are significant risks to the outlook for 2019. The Federal Reserve may tighten too much; profit margins may come under pressure sooner than anticipated; trade tensions may escalate or diminish; and geopolitical strife may force oil prices higher.
  • While bonds have historically been a reliable hedge against equity exposure, stock/bond correlations have turned positive twice this year. This shifting dynamic, coupled with lower expected returns from public markets, suggests the need for broader diversification.
 

Introduction

2018 has been a difficult year for investors as long bull markets in both U.S. equities and fixed income have encountered strong headwinds, and international stocks have underperformed following a very strong 2017. Shifting fundamentals in an aging expansion have certainly played their part in slowing investment returns, as the U.S. Federal Reserve (Fed) has gradually tightened U.S. monetary policy, a new populist government in Italy has revived Eurozone fears and Middle East turmoil has led to more volatile oil prices.

However, the single most important issue moving global markets in 2018 was rising trade tensions, and this will likely also be the case in 2019. In a benign scenario, the U.S. and China come to an agreement on trade issues, potentially allowing the dollar to fall and emerging market (EM) stocks to rebound following a very rocky 2018. In an alternative scenario, an escalating trade war could slow both the U.S. and global economies with negative implications for global stocks.

However, the single most important issue moving global markets in 2018 was rising trade tensions, and this will likely also be the case in 2019. In a benign scenario, the U.S. and China come to an agreement on trade issues, potentially allowing the dollar to fall and emerging market (EM) stocks to rebound following a very rocky 2018. In an alternative scenario, an escalating trade war could slow both the U.S. and global economies with negative implications for global stocks.

As global growth rates come back to trend, we expect renewed scrutiny on monetary policy. The Fed has followed a seemingly preordained path of rate hikes for much of 2018, and we expect hikes to continue, quarterly, until mid-2019. Nevertheless, Fed speakers are beginning to lay the groundwork for a shift to data dependency in their rate setting. With other central banks also withdrawing stimulus and increasing rates, Fed data dependency may be cold comfort to investors should growth falter and the market narrative pivot toward a sense that U.S. policy is tight. To be clear, tighter policy doesn’t imply looming recession. But in combination with softer growth it makes for a more fragile economic mix in which business, investor and consumer confidence may struggle to withstand negative news flow from issues like trade and geopolitics.

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