“Quantitative Tightening Highlights Global Growth Weakness”
The preponderance of economic and fundamental data released recently would suggest market performance could be challenging in 2019. With December 2018 stock market performance the second worst in history,1 it’s tough to imagine a quick resumption of bull market conditions leading to new highs. How did we get here, and what could turn this bleak outlook around?
Setting the Stage for Weak Growth
The 2008 Financial Crisis roiled markets and weakened the financial system globally. In the U.S., Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson hatched a plan to avert a collapse into a second Great Depression by crafting an unconventional monetary policy approach that featured zero interest rates (ZIRP) and quantitative easing (QE). With these policies, they hoped to pump up depressed asset prices and promote “consumer wealth effect spending” to drive GDP growth. As we look back over the past 10 years, we can see their policies were not only effective but successfully supported asset prices, culminating in what has been credited as the longest bull market cycle for equity and bonds in U.S. history.
Unfortunately, unconventional approaches can also produce unanticipated side effects that may become particularly problematic over time. The anemic economic growth and absence of inflation pressure in the U.S. and worldwide are consequences of the monetary policy approach used to forestall calamity. Massive increases in government debt tend to weigh on economic growth as more and more economic resources are consumed by public financing initiatives and debt service payments. The weak growth rate that has only averaged 2.0% over the past 10 years is emblematic of the lack of real recovery from the deep economic and financial system structural problems caused during the Crisis.2
While implementing ZIRP and QE, Chairman Bernanke repeatedly warned a dysfunctional Congress of the need to pair monetary policy with a strong fiscal response to lift GDP growth to normalized levels. Last year’s above-trend 3-plus percent GDP growth rate, the first in a decade and driven by tax cuts and defense spending, are a testament to the need for fiscal stimulus to sustain growth. Raising interest rates while reducing the Fed’s bloated balance sheet has resulted in initial signs of slowing growth in the U.S. At the same time, European and Asian economies are moving from slower growth to outright contraction as their central bankers struggle to end the supportive monetary policy.
It seems obvious that the Fed has made a policy error in assuming they can move from QE to QT (quantitative tightening) while raising rates to a level that would be considered normal in prior recovery cycles that featured much stronger growth. This cycle’s anemic or low growth was supported by the most massive monetary stimulus program attempted since the Great Depression. Why then would they assume the economy could absorb a classic tightening approach without it quickly impacting growth?
Concerns for 2019
As we try to envision economic and market conditions for 2019, we think QE/QT policy side effects will dominate the outcome not only for the year but maybe well into the next decade. We have several major concerns for investors as we move into the new year:
Global Growth and Corporate Performance
Forecasts for global growth and corporate performance are overly optimistic and will be adjusted lower to rationalize a combination of deteriorating data and geopolitical overhang.
- The International Monetary Fund (IMF) recently cut global growth forecasts for 2018 from 3.9% to 3.7%. U.S. companies reversed robust capital expenditure (CAPEX) spending in the first half of 2018 that averaged 10% to 0 in the third quarter, suggesting corporations are anticipating a weaker business cycle in 2019.
- Revenue growth in Q3 and forecasts for Q4 point to slowing top and bottom line growth. Revenue and profit forecasts for 2019 have been guided lower and are still likely to be revised down as expectations for growth fade.
- Corporate buybacks, a major source of liquidity for the stock market, may dry up as corporate performance stumbles in the second half of 2019.
Slow Consumer and Business Spending
Q4 negative market performance is likely to weigh on investor sentiment and business sentiment, causing a slowdown in consumer and business spending. With the earnings cycle peaking in Q3 of 2018, investors will look to reprice overvalued stocks.
Investment-grade and high-yield corporate debt have been squeezed as the yield curve flattens and refinancing risks increase. Look for high yield angles to lose their wings as default concerns rise.
Interest Rate Sensitivity
Interest rate sensitive sectors of the economy, like housing and real estate, will continue to slow materially as the Fed’s dual tightening program starts to take a big bite out of growth.
- The recent comments from the Federal Reserve and Chairman Jerome Powell indicate they have been caught off guard by how fast economic data has been deteriorating. People fail to realize that balance sheet reduction and Fed tightening has never occurred in tandem before. The historically weak economic recovery from the Financial Crisis and the lack of strong growth further compounds the U.S. economic system’s ability to absorb the impact of rate hikes.
- With the eighth rate hike in December 2018, the Fed has increased its Federal Funds Rate from just 0.25% to 2.50%, which looks benign until you realize it represents a 900% increase. To put that in historical perspective, the last couple of rate increases were modest by comparison: 425% pre-Financial Crisis and 117% before the Dot Com Market Bubble burst.
- Yield curve inversion has been a good predictor of economic and market trouble ahead, and we believe yields would be providing an even more powerful inversion signal if the Fed’s balance sheet reduction was not weighing on bond prices and driving up yields.
Geopolitical strife will weigh on markets as trade tensions increase in intensity during the first half of the year and a plethora of other international concerns buffet markets worldwide, including:
- Democrats shifting political and media pressure on Trump into an even higher gear as the party positions for 2020 elections.
- The U.S. Congress becoming a “house even more divided,” setting up a partisan battleground that will leave the American people casualties on the field. A perfect example is the year-end government shutdown that unnecessarily increased economic and market risk and compounded investor anxiety.
- Further Brexit deal delays or a new referendum nullifying the exit plan as Britain is torn asunder by its populist movement.
- Turmoil will become a constant until a resolution materializes.
- Brexit fallout will slow growth in Great Britain and Europe further.
- China’s growth continuing to slow as their economy contracts. As their economy stumbles we expect credit risks to increase dramatically as non-performing bank and shadow banking loans default.
- The heavy and increasing load of consumer, corporate, and government debt combined with slowing growth may cause fears of a debt crisis in developed markets by late 2019.
- In 2017, the major economic story was about synchronized global growth. In 2018, it became about the divergence between a faster growing U.S. than the rest of the world. In 2019, we are likely to see global economic growth falter and a short period of synchronized recession.
How to Ramp Up Growth in 2019 and Beyond
We expect the market to move mostly lower in the first half of 2019 as the consensus opinion about economic growth and corporate performance turn negative and stocks are repriced. The long-awaited rotation from growth and momentum stocks to value and high dividend stocks should come to fruition as the markets search for a bottom. Markets could easily lose an additional 20% or more from the modest year-end declines posted by major U.S. indexes.
We could avoid an additional market sell-off if the Fed realizes their policy mistake, abandons future rate hikes in the first half of 2019, and then starts to move rates lower by year-end. This could take place as the Fed processes first-quarter economic and corporate performance data. Once they move from tightening to easing the markets should respond as investors become comfortable again that the Fed is supporting asset prices. The economy must grow faster to build another bull market trend, and corporate performance needs to follow suit. Additional fiscal stimulus would be required to boost the economy and bull market cycle. We would also look for more fiscal stimulus towards the beginning of 2020. The combination of Fed monetary support and much needed fiscal stimulus for infrastructure could get the U.S. back to sustainable growth. The big stumbling block beyond political dysfunction for additional infrastructure spending is that Americans don’t want to balloon the deficit further. With more than one trillion in deficit spending projected over the next few years just to fund current obligations, who can blame them.
As we view the economic landscape globally, it seems the number one problem is a lack of growth. Moreover, since the U.S. has the healthiest economy and financial system, we are destined to lead the rest of the world to faster growth through the right policy development or into economic calamity if we don’t stem the tide of slower growth, recession, and bear market conditions. More rapid economic growth increases positive sentiment and can drive consumer spending, which in turn drives corporate spending. The key is to keep growth rates high so the economy and financial systems can finally put the Financial Crisis conditions in the rearview mirror. If the Fed, trade policy, and corporate performance become more supportive, then this improved narrative could forestall the current bear market trend and allow stocks to move slowly higher.
The Fed proved to have the right policy answers during and after the Financial Crisis to prevent disaster. Their bloated balance sheet could be the answer to needed fiscal stimulus to fund infrastructure spending over the next decade. The extra $3.5 trillion on their balance sheet was used to promote QE operations and is already in our deficit. These are dead assets that can be recycled to breathe new life into the longest U.S. expansion on record. We would suggest the Fed peel off $2 trillion to fund a national infrastructure bank that could be managed as the primary funding source for long-term infrastructure needs. Partnerships with states and private industry could extend the funding by trillions more. Sustained economic growth rates of 3-4% or more would normalize inflation rates and provide the backdrop for the Fed to raise rates to normal levels without causing a recession. Growth at this level in the U.S. would certainly help lift international economies to faster growth and a resurgence in prosperity. While this is an unconventional approach to solving long-term structural problems, the pieces of the puzzle are in place to create a better economic mosaic.
Keep your seat belts firmly fastened — it’s likely to be a bumpy ride as market conditions adjust to slowing fundamentals. At the turning points of market cycles, investors often chase returns that turn out to be nothing more than phantoms. The “fear of missing out” (FOMO) causes them to buy high and then sell low as markets gyrate up and down. As we have seen over the last quarter of 2018, the big up days are a head fake and unfortunately set up investors for large bear market losses. As losses accelerate, many investors are driven from the markets only to lock in losses. Sometimes protecting principal and holding cash is the smarter option.
As we move into the second half of 2019 and beyond, bear market corrections could offer investors a tremendous value proposition after stock prices drop and recovery begins. To be successful, investors need to buy low and sell high and to wait patiently until those opportunities become apparent. As markets start to build a new bull market trend after bear market declines, there is typically a shift in investor preference away from growth and momentum stocks in favor of value, yield, and small and mid-cap stocks that have better growth potential than large-cap brethren. Until then, cash or money market accounts, U.S. Treasuries, and defensive high yielding dividend-paying stocks may be a smarter choice. We believe minimizing losses to preserve capital gives you the ability to compound return on a larger capital base. Losing small is the most important thing you can do to increase investing success over an investor’s lifetime.
Past performance does not guarantee future results. The views presented are those of Don Schreiber, Jr., and should not be construed as investment advice. Don Schreiber, Jr. or clients of WBI may own stock discussed in this article. All economic and performance information is historical and not indicative of future results. This is not an offer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or profitable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request.
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1 Gunzberg, Jodie. “The Second Worst December is Only Half the Story.” Seeking Alpha. Jan. 3 2019.
2 Trading Economics, 2018.