The U.S. stock market is enduring an early winter, as losses since Sept. 30 erased nearly all the year’s gains in the S&P 500 index. Some of the biggest winners during the first three quarters of the year were among the biggest losers during the downturn.
Since Sept. 30, Facebook (ticker: FB), Apple ( AAPL), Amazon.com ( AMZN) and Netflix ( NFLX) have suffered double-digit declines, with Netflix and Apple the hardest hit. Semiconductor high-flier Nvidia Corp. ( NVDA) fell by nearly 40 percent.
The market staged a short-lived rally following the trade “truce” negotiated between President Donald Trump and Chinese President Xi Jinping. However, doubts about what agreements were actually reached at the dinner and the announcement that hard-liner Robert Lighthizer would be leading trade negotiations contributed to an abrupt about-face in market direction.
Investors are worried that recent volatility signals the end of the bull market and that the transition from bull to bear market is imminent. A bear market seems inevitable given the length of the current bull market, however, the timing may not be as imminent as investors fear. Despite signs of slowing economic growth and worries about geopolitical strife, several factors point to recent market conditions as a pause rather than the end of the bull market.
Growth is slowing, but a recession may be a year or more away. Growth was boosted in the first half of the year by tax cuts and spending increases, creating something of a “sugar high” in corporate earnings growth expectations. Hopes for FAANG and other high profile technology stocks became particularly optimistic, and were vulnerable to rising interest rates, competitive pressures and regulatory scrutiny.
Investor optimism from earlier in the year has been challenged as signs of slowing manufacturing growth and falling oil prices cause investors to revisit growth expectations. However, sentiment may have shifted too far, with the excessive exuberance of late 2017 replaced by excessive pessimism in late 2018. Leading economic indicators signal slowing growth rather than contraction, and manufacturing growth remains positive in the U.S. and in much of the world.
Falling oil prices added to worries about slowing growth, however, the fall in oil prices may have more to do with an abundance of supply rather than a shortage of demand. The Trump administration granted waivers of sanctions on Iranian oil exports to eight major importers, which effectively added more than 1 million barrels per day to the global supply of oil.
The continuing bright spot for economic growth is the American consumer, benefiting from a tight job market, long-overdue wage increases and healthy personal balance sheets. U.S. economic growth is likely to slow from the rapid pace of the first nine months of the year, but is a long way from the type of contraction that typically causes a bear market.
The Federal Reserve isn’t “loco,” but investors are concerned about the potential for the yield curve to invert. An inverted yield curve, which is when the two-year yield is higher than the 10-year yield, is considered one of the most reliable indicators of an upcoming recession. The yield curve narrowed to 11 basis points (0.11 percent) on Dec. 4, the tightest spread since 2007. And, the yield of five-year Treasurys recently dropped below the yield of two-year and three-year Treasurys.
Fed policy has been motivated by economic and systemic factors. Tight labor markets are creating long-overdue wage growth, fiscal stimulus may contribute to inflationary pressures and tariffs may cause a boost in consumer goods inflation. Federal Reserve Chair Jerome Powell is also worried about potential asset bubbles, a logical concern given that past periods of “easy money” gave rise to excesses in commercial and residential real estate, technology, and commodities. The Fed is likely to raise rates this month, but slowing growth and the potential inversion of the yield curve may motivate Powell and the Fed to hit the pause button in 2019.
The midterm election results are important politically, but don’t significantly change the investment outlook. Some investors have been hoping for a major infrastructure spending bill or another round of significant tax cuts. Research firm TS Lombard may have the best summary of the outlook for infrastructure spending, “Infrastructure is like the weather, everyone likes to talk about it, but no one can do anything about it.” There may be bipartisan consensus for some form of infrastructure spending, but the magnitude of a deal is unlikely to be an economic game-changer. The same is true of a “tax cut 2.0.” bill.
Midterm results also won’t significantly change the outlook for trade policy. Trade remains the Trump show, as the executive branch has considerable latitude to impose trade sanctions.
Policy uncertainty is a concern. Corporate tax reform was expected to be a catalyst for U.S. companies to increase capital spending. Business spending has fallen far short of expectations, with uncertainty about trade the likely cause. Rising input costs as a results of tariffs and the potential for supply chain disruption creates uncertainty, hindering long-term planning for many corporate CEOs. The announcement of plant closures and job cuts by General Motors Co. ( GM) highlights the challenges faced by many American manufacturers, and the disconnect between political promises and economic realities.
Economically, a trade war hurts everyone. A deal with China, particularly one that protects intellectual property, would be a positive for the U.S. economy and equity markets. Unfortunately, the political calculus complicates matters. There is bipartisan anger toward China and trade is a potent political chip. Trump and Xi may ultimately arrive at a face-saving deal for both sides, but the road to get there is likely to cause considerable market volatility.
Investors became complacent last year as equities steadily advanced and volatility remained low. Recent volatility may seem unusual, but rapid swings in prices are far more common than 2017’s placid environment. In 21 of the past 38 years, the S&P 500 had an intra-year drop of 10 percent or more. Drops of 15 percent of more occurred about one-third of the time. Despite the intra-year volatility, the S&P 500 provided positive returns in 29 of the past 38 years.
Despite concerns about slowing growth, rising rates and policy uncertainty, the bear may remain in hibernation for a little while longer. Continued U.S. economic growth, an easing of policy uncertainty and a modest rebound in Chinese growth will be a likely recipe for a final run-up in equity prices before the next bear market.
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