By Henry Ma, Julex Capital
Market weakness in last two weeks has made many investors restless. As of yesterday (December 14th), the S&P 500 Index has lost 5.7% in December. All the major indexes have slumped into correction territory for the first time since March 2016. In our opinion, the selloff was largely driven by a weakening economic growth expectation, and to a lesser extent algorithmic trading and 2-year and 3-year yield curve inversion.
At the end of November and beginning of December, there were some positive developments in easing concerns about interest rate hikes and trade war tensions.
In his speech at the New York Economic Club, Fed Chairman Jerome Powell said “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy…” This “just below” language is different from the more hawkish “long way from neutral” characterization he gave at the beginning of October. The market rallied after his speech.
On December 1st at the G20 Summit in Argentina, President Trump met with Chinese counterpart President Xi. They agreed to put a burgeoning trade war on hold as both leaders said they wouldn’t impose new tariffs for 90 days while the world’s two largest economies negotiate a longer-term deal. Recently, Chinese officials have begun preparing to restart imports of U.S. soybeans and liquefied natural gas as a goodwill gesture.
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.
Disclosure: This article is for the purpose of information exchange only. It is not a solicitation or offer to buy or sell any security. You must do your own due diligence and consult a professional investment advisor before making any investment decisions. All information posted is believed to come from reliable sources. We do not warrant the accuracy or completeness of information made available and therefore will not be liable for any losses incurred.