However, concerns about an economic slowdown in both the US and the rest of the world and the arrest of the CFO of Huawei – the largest mobile phone producer in China – overshadowed those positive developments. Additionally, many analysts expect a deceleration of economic growth in 2019 driven by tariffs, the fading impact of the tax cuts and higher borrowing costs caused by the Federal Reserve. Globally, tariffs and other protectionist policies are likely to hurt the economic growth in emerging market countries next year. The US GDP growth is on pace for 3% this year, but it is expected to slow down to around 2% next year.
The inversion of the yield curve between 2-year and 3-year rates triggered more concerns about possible recession as well as selling pressure from algorithmic traders. Historically, an inverted yield curve is a good indicator for an upcoming recession. Many algorithmic traders use yield curves as one of the factors in their model. Nowadays, about 70% of overall trading volume is conducted through algorithmic trading. When the curve was inverted on December 4th, the S&P 500 Index fell by over 3% in just a few hours. It is highly likely that algorithmic traders were involved in the selling.
What is our outlook for 2019?
We would like to share some of my thoughts as we look forward:
- Economic growth will likely to be around 2% in 2019, in line with the consensus view. The impacts of the Trump tax cuts will continue to gradually fade out. A split Congress will likely prevent any new tax cuts or spending packages to be passed through 2020. Given a current low unemployment rate and slow productivity growth, there isn’t much room for strong economic performance.
- The Fed will likely raise interest rates this month and a maximum of two times in 2019. The yield curve between the 3-month and ten-year rates may be inverted in the second half of 2019. In the face of slowing economic growth and recent market turbulence, the Fed seems ready to slow the pace of rate hikes, as indicated in the Chairman Powell’s speech.
- Trade tensions will continue generating headline risks. Although there is a 90-day truce between China and the US, whether both sides can reach an agreement is still uncertain. It is unclear how much China is willing to change its trade and industrial practices to meet the US demands. Issues like intellectual property protection and market access are harder to address than just the trade deficits.
- Earnings growth will probably slow down. Earnings growth for the S&P 500 companies, helped by the tax cuts and strong economic performance, has been over 20% every quarter this year. With the fading impacts of tax cuts, slowing economy, rising wages and tariffs, corporate profits will suffer next year.
In general, we don’t believe the US will be in bear market territory next year, but the upside potential for US equities may be limited given current expensive valuations and a slower economic growth outlook. Although the current earnings are still strong, we look for a significant deceleration in earnings growth next year. The cyclical sectors, for example, high-valued tech stocks, are more vulnerable in this late cycle. The good news is: the recent selloff may have removed some of the excess valuation and offers a starting point for better performance in 2019.
Henry Ma is the President & CIO at Julex Capital Management, a participant in the ETF Strategist Channel.
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