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On Point

February 2019

V for Volatility

After pulling out of the December nosedive, stock indexes recovered nearly all of those losses in a V-shaped January recovery, despite relatively little change in economic and corporate fundamentals. What did change to a large degree is the monetary policy of the Federal Reserve, which pivoted sharply away from a commitment to tightening, avoiding a potential policy error that could have threatened the ongoing economic expansion. With the Fed stance softened and the market recovered, the question is, is all clear? While recession remains off the radar, the Fed did change its tune for a reason: the outlook for fundamentals is softer than at present, which warrants a measure of caution.

Recent economic growth is solid, particularly in the US, but looks to be slowing somewhat. Employment reports continue to show impressive strength without enough wage acceleration to warrant inflation concerns yet, though that could change as the labor market continues to tighten. Following a stimulus-enhanced 2.9 percent growth in US GDP last year, Wall Street economists project a gradual but decided slowdown to 1.8 percent. That prediction is not overly troubling in itself, but the slowing theme is fairly widespread. Sales of new homes and autos have dipped notably lately, and banks report weakening loan demand, with headwinds from higher interest rates and diminished confidence among small businesses and consumers. Globally, the OECD measure of leading economic indicators has fallen to its lowest level since the last recession.

Corporate profits present a similar dynamic. 2018 was a banner year with S&P 500 earnings per share (EPS) growth of about 23 percent from the prior year. Going forward, though, earnings growth faces several headwinds: tax cuts drove around half of that growth that will not repeat; revenue growth that looks likely to slow with the economy; and profit margins that may be peaking as labor costs rise faster than prices. The average estimate has already declined from 10 percent EPS growth in 2019 to half that, and some analysts are projecting no growth at all. Of course, many individual companies will record strong results, and therefore our selection of securities and mutual fund managers looks to be especially important going forward.

Other factors could hold some sway over the market and economy this year, notably trade and geopolitical negotiations, which are challenging risks due to their unpredictability and high stakes. US negotiations with China, in the worst case, could result in tariffs borne by US consumers that overtake what is left of tax-reform stimulus. In a favorable case, existing tariffs could be lifted and access to China’s markets could expand for US exporters. On the Atlantic side, decisions determining the US trade policy stance with Europe loom, with more tariffs possible. The future of Brexit remains cloudy as ever, and the downside risks are considerable. These negotiations could all work out favorably for markets, but the decision makers have political factors to consider, so interests are not always aligned. Still, none necessarily threatens a US or global recession.

It is also worth making clear that a softening economy does not mean recession, and there is scant evidence that the end of this expansion cycle is imminent. But a slowdown does raise the bar for companies that have widely enjoyed a swiftly rising tide. With its newly flexible stance, the Fed could even begin to ease again if necessary, unless and until inflation forces its hand. Still, in spite of the recent market recovery, challenges are clearly evident on the horizon of the investing landscape, and caution will be key in navigating continued volatility.