In the short run, markets behave like a voting machine. In the long run, they’re a weighing machine. As a weighing machine, markets focus on fundamentals and valuation. In the short run, investors are easily distracted by uncertainty and emotion. That observation was originally made by Benjamin Graham.1

  • After a sharp selloff at the end of last year, markets are refocusing on fundamentals and a macro environment of economic growth that is slowing but remains durable
  • 2018 fears that the Federal Reserve was on track to significantly tighten financial conditions have dissipated, as the Fed has now signaled that it will be patient in its policy decision making
  • We maintain conviction in an overweight to U.S. equities. We have added to core bonds and extended portfolio duration as the cycle has matured

Late last year, markets behaved like a voting machine. Having seen investor capitulation in December—exaggerated by year-end market illiquidity—we’re beginning to see markets find their footing. It was a riotous fourth quarter. There isn’t a worse December on record for the S&P 500 since 1931. According to EPFR Global, equity markets saw $108 billion of outflows in the fourth-quarter, $105 billion in December. I imagine tax-loss harvesting contributed to December outflows.

Investors are refocusing on fundamentals (Figure 1). With the exception of December, I view investors demanding a higher risk premium as merited. Risks are higher. With fear that the Fed would overshoot on policy tightening, we also saw a year-end dash by Wall Street analysts to see who could most quickly revise earnings estimates lower. “Run for cover” seemed the call to action for year-end earnings guidance. It felt similar to year-end fearmongering about an impending recession.


A line graph shows 12-month forward Earnings Per Share and the Price Index between 2006 and January 2019. The line tends to trend downwards until about 2009, and trends upwards during periods thereafter, with both lines at about 160 today.

As we’ve moved through the current earnings season, balance is coming back to the earnings outlook. 2019 earnings growth is not going to repeat last year’s extraordinary performance. We’ve seen peak earnings growth. I do not believe we have seen peak earnings. That’s a key reason why we remain overweight U.S. equities. Our base case is for earnings to grow in line with nominal GDP this year.

While the bounce seen across equity markets since December is notable, investors need to recognize we’ve simply reset index levels back to where markets were trading before December’s dramatic sell-off. Bottoming is a process, not an event. I say that because I feel the recent recovery is deserved and fundamentally driven. I expect markets can bounce along in their current range until Ben Graham’s weighing machine fully re-engages. Confidence takes time to rebuild.

Had 2018 ended in October, we would have had a year where markets were volatile but effectively went nowhere. Coming off what was an extraordinary year for risk assets in 2017, last year should have been a year when markets gave back some of the returns 2017 pulled forward. Markets can get ahead of themselves. That observation applies equally to rallies and corrections. 

If I were to annualize global market returns over the last two years, those returns would reflect what you’d expect to see late cycle. Mid-single-digit returns are a reasonable base case to expect for equity markets this late in the cycle. Low-single-digit returns are a reasonable base case for core bonds. 

The important difference between 2017 and 2018 was volatility. 2017 was anything but normal in that we effectively saw no market volatility. While this past December seemed exaggerated, I want to make the point that last year was a far more normal market environment than 2017. Volatility is back. Price discovery is healthy for markets. Markets aren’t meant to move only in a straight line.

I asked a simple question at the start of last year. Is this as good as it gets? My answer at the time was no, acknowledging we were getting closer to it. What a difference a year makes. We thought we would see above-trend global growth the first half of last year and that the pace of global growth would peak, returning to trend in the first half of 2019. With bumps, that’s how it’s playing out.

I think it’s now fair to say that the current cycle is about as good as it’s going to get. That isn’t the same as saying the cycle is over, which somehow gets lost in the noise. We’ve been talking about being late cycle for well over a year. The length of this cycle isn’t new news, nor is a rising risk of recession. The longer a cycle extends, the closer we get to recession. 

It is important to question when the cycle will end and what can break it. Identifying when we think a macro cycle begins to roll over is important. Pretending to do so with exact precision is folly. As I mentioned early last year, 2020 seems a reasonable line in the sand for when recession risk becomes more pronounced. 

Pulling recession risk into this year seems overdone. We still have 2019 to get through. If I had to put a very rough number on the probability of recession this year, I would say it’s around 20%. That isn’t a negligible number. But it’s no higher than what I thought about the risk of recession last year.

Late last year, market pundits were almost tripping over themselves to see who could be first to cry recession. It became too easy to be an alarmist, and alarmists are unsettling. That’s especially the case when investors are anxious. Recessionary scaremongering seemed very much in fashion late last year. To a certain extent, it still is.

Global growth continues to slow from above-trend to trend levels. Trend growth remains uninspiring on a headline basis. I continue to believe the mix of slower growth and tame inflation is allowing this cycle to run as long as this. We seem stuck for the moment in a low-growth equilibrium environment. That’s good news, as long as inflation expectations remain in check.

In simple numbers, trend growth in the U.S. is about 2%. In Europe, it’s closer to 1%. Trend global growth sits around +3.5% (Figure 2). As a base case, I think those are fair numbers to target for the year ahead. That said, while slowing to trend growth may not seem exciting, I’m going to make the argument that it’s reflected in equity as well as credit market valuations. 

A line graph shows real GDP year-over-year between 2004 and 2018, with projections from the IMF for 2019 and 2020. Since 2012, the line has been hovering between 3–4%.

Global growth may be slowing, but it’s also still growing. That point seems disregarded. While global growth was tilting to the upside at this point last year, it’s now tilting down. My concern about the low level of global growth is that it doesn’t leave much room for a policy error. It won’t take much to shift sentiment lower, which in turn can weigh on the pace of growth ahead.

What set markets off on their wild ride in the fourth quarter had little to do with U.S. and Chinese trade policy, rising concern about earnings growth, political populism, or the durability of economic growth. Those issues were well identified. 

Markets became jittery last October because of exaggerated concern the Fed was about to end the expansion by over-tightening monetary policy. As global macroeconomic data began to roll over mid-year, the Fed continued its drum beat about the underlying strength of the U.S. economy, a tightening labor market and tighter monetary policy ahead. 

What was initially viewed as refreshing about Chair Powell became a concern: He speaks directly about the economy. Any new central bank head has their work cut out for them in finding the right way to speak to markets. It didn’t help that the White House, at the same time, was expressing concern that the Fed needed to stop hiking interest rates.

I prefer the direct language that Powell has chosen to engage with markets, but he needs to better reflect on a market’s emotional state. That was something he didn’t do last October. When markets are jittery, it’s important to address why. If not, investors extrapolate the best or worst of what they want to hear or fear, regardless of what’s being said.

Words matter, especially how they’re delivered. I continue to take the Fed at its word. Approximating a neutral policy rate is important to help anchor policy discussion. Targeting a neutral rate with precision is a fool’s errand. Powell has said as much. With policy rates sitting at about neutral, the Fed can continue to point to the strength of the U.S. economy (Figure 3). With no meaningful pass-through from tighter labor markets to core inflation, it also needs to underscore data dependency.

A line graph compares Average hourly earnings (LHS) and the Unemployment rate (RHS inverted), from 2008 to January 2019. The unemployment rate has been declining and is near historical lows at about 4%, and average hourly earnings have been increasing year-over-year.

It helps that Chair Powell continues to reinforce the Fed remains data dependent as it thinks about future rate hikes—also, that the Fed’s balance sheet is part of an expanded policy toolkit that is not on autopilot. I do not believe the Fed is programmatically set to tighten rates or sell down its balance sheet. 

The Fed is on hold until the data changes, and it has now said as much. That clarification is supportive of markets.

Real policy rates across developed markets remain accommodative. While I would have said that 10-year government bond yields in the U.S. should be closer to 3.25% last year, I have a difficult time envisioning them above 3% this year. 

The Fed is on hold with regard to rate hikes. The European Central Bank (ECB) and the Bank of Japan (BoJ) are as well. If I were pushed, I would make an argument that both the ECB and BoJ will find themselves having to ease monetary policy again before tightening. Embedded in that remark is an observation that the U.S. dollar should remain supported in its current trading range.

Market headlines continue to suggest that equity valuations do not fully reflect the long list of political and policy concerns that fuel investor uncertainty. Headlines also indicate that valuations don’t recognize the slowdown in earnings growth we expect to see this year versus 2018. We believe they do. 

We would not have added to equity positions in late December and early January had we thought differently. We haven’t added again to our overweight in stocks for the simple reason that we view risks as higher this year than last. That observation is about the amount of risk in portfolios, not the direction of markets. We want to ensure that we’re appropriately diversified, not overreaching for risk. Late in a market cycle, diversification is essential. For long-term money, as the December rout and 2019’s rapid recovery have shown, so is staying invested.

We’ve seen global equity markets de-rate by about three price-to-earnings forward multiple points over the past year. That places valuations near yet below 20-year averages (Figure 4). A market anchoring on average valuations signals that it’s trying to find equilibrium. That doesn’t mean markets can’t go lower or higher. It does mean many of the risks we are watching seem embedded in valuation levels. 

A line graph compares the MSCI World next 12-month price-to-earnings ratio with the 20-year average, from 1999 to January 2019. In the end of 2018, the next 12-month P.E. ratio was relatively in-line with the 20-year average, but the start of 2019 saw the ratio dip well below the 20-year average.

I would say the same about credit markets currently. Both higher quality and extended credit sold off dramatically in the fourth quarter of last year. They’re now recovering. We are seeing new issuance and investor inflows in areas as well. With the Fed on hold, that also lends support to credit markets.

The increase we’ve seen in non-financial corporate debt is center stage, as investors search for what might push the global economy into recession. It’s right to be concerned about the expansion we’ve seen in leverage since 2008. That said, I do not believe we are set to see a repeat of 2008, a systemic collapse in markets because of leverage.

Looking at non-financial corporate debt, including loans, we are back to absolute levels as a percentage of GDP associated with prior recessions in the early ’90s, the early ’00s (with technology and telco), and in the 2008 financial crisis. 

We’ve proactively reduced exposure to credit across portfolios for well over two years. In a Balanced portfolio, we held between 30 and 40% of our fixed income allocation in extended credit in 2016. Since then, we have increased portfolio quality, added to core bonds and extended portfolio duration as rates have risen. That same balanced portfolio today has about 6% of its fixed income allocation in extended credit. That represents a portfolio level allocation of about 2%.

I do not believe corporate debt will cause the next recession. It will certainly go along for the ride. Over a twelve month period, leverage on its own is a poor signal for recession. You need to balance out leverage with affordability. Comparing debt servicing ratios to history tells a more durable story. After-tax profits are strong, even with rising labor costs, thanks partly to tax reform.

If you asked me one year ago how politics factors into our investment process, I would have said it matters when it directly impacts policy. That was certainly the case with U.S. tax reform, which has helped us have conviction in an overweight to U.S. equities. After-tax earnings are growing.

What made last year particularly frustrating is that the epicenter for rising investor uncertainty was politics. Politics is now part of the market narrative, in particular as it relates to sentiment. The U.S. government shutdown, not to mention “yellow-jacket” protests in France and global trade friction, will distort first-quarter economic data.  

Brexit remains a real concern. I continue to be surprised by how complacent markets appear about the knock-on effects of a no-deal, hard Brexit. I hope rational minds prevail and we see an extension of the deadline to leave the European Union. A hard Brexit ends badly.

Markets prefer political stasis. We’re entering a world where political noise can exaggerate downside risk to markets. Should political noise become more incendiary, it will weigh on sentiment. Today, politics seems to be more important than policy. For investors, that’s a particularly prickly place to be. 

While emotion can get the better of investors, fundamentals are what matter. I’m appreciative that markets can quickly switch from fundamentals to emotion. That creates investment opportunity, as we saw in December and early January. 

We’re long-term investors. Over a cycle, I firmly believe that markets are a weighing machine.

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