2018 Recap

Volatility is back. In 2018, the markets were met with worries over trade disputes, a tightening labor market, rising interest rates and some vivid signs that the economic cycle may be nearing its end. While some of the major themes that emerged in 2018 were tough to anticipate, we did finish the year with most of the ideas we shared last year playing out as expected.

Here were our themes:

  • Electric vehicle (EV) adoption would accelerate: While overall vehicle sales were flat to lower globally year-over-year, sales of EVs surged 74% in China and 109% in the United States through October.1 We expect this growth to continue.
  • The shift to value-based healthcare would benefit managed-care companies: This industry group outperformed the S&P 500 by double digits through November as more people became insured and a split Congress made it more difficult to roll back Medicaid expansion. We think these insurers are well positioned in what’s likely to be a more challenging equity market in 2019.
  • A more balanced oil market: This also came to fruition, with markets actually moving into deficit for much of the year. Inventories were drawn to their seven-year averages, helping to lift prices as much as 27% from December through September. But as a surplus emerged on robust U.S. supply and still-present Iranian oil, prices collapsed. We expect oil to trade toward the bottom of the $60–$80 per barrel range this year.
  • Challenges for the auto industry: Slowing sales, rising costs and tariff uncertainties weighed on the sector, which significantly underperformed the broader market. Growth in U.S. auto loans slowed measurably, and we don’t see much cyclical upside from here.
  • Global capex would continue to rise: This idea did NOT play out as we thought. And as capex acceleration failed to materialize, so did the expected upside in commodities. But there was one bright spot: the intangible capex. Cloud capex for the biggest tech companies grew by 50% in 2018, a growth rate that will likely moderate in 2019.2

Looking ahead, we expect downward earnings revisions, margin compression, tighter monetary policy and fading fiscal stimulus to challenge equity returns. Here are our five top ideas for 2019:

A rotation to high-quality, low-risk growth should continue

Through the end of October, one thing was clear: Large-cap companies of higher quality and with lower risk outperformed their lower-quality, higher-risk, small-cap counterparts. Drilling deeper, high-quality outperformed low-quality by 1.2% from January to October, and by a much wider 4.3% in October alone.3 This is consistent with the factors that we expect to typically outperform in the late stages of an economic cycle when growth is still above average, but there are signs of slowing. Indeed, our economists expect U.S. GDP to grow at an above-average 2.4% in 2019—slowing from 2.9% growth in 2018.4

In an environment where we expect lower risk-adjusted returns from equities, we favor companies that have strong balance sheets, higher ROEs, higher earnings visibility, lower betas and growing dividends. Sectors that could hit the mark include healthcare, defense, consumer staples and utilities—and we are optimistic on select stocks within these sectors. Importantly, the same factors used to come up with this late-cycle quality screen are also those that tend to outperform in an end-of-cycle recession scenario.

Bar chart compares the performance relative to equal-weighted S&P 500 across various business cycles (early-cycle, mid-cycle, late-cycle and recession) and factors (high-quality, low-quality, low-risk, high-risk, large-cap and small-cap). The chart highlights that in late-cycle, the factors that perform best are high-quality, low-risk and large-cap.

Wage inflation is likely to accelerate, pressuring margins in some sectors

We see multiple potential headwinds for margins this year, but our focus is on wage pressures amid a tight labor market. Our economists expect average hourly earnings to rise by 3.3% this year, up from 2.8% in 2018.5 Most recently, the employment cost index rose by 3% to its highest level since the end of 2008—with the underlying details showing broad wage gains.

We also see it in the headlines—whether it be increased political scrutiny on companies’ compensation or moves such as Amazon’s decision to increase its minimum wage to $15 an hour. Further, analysis of 400 earnings transcripts during the third quarter found that wages were the most widely discussed cost pressure, with 17% of companies singling them out.6 Overall, 45% of the S&P 500 companies mentioned at least one cost headwind.7 This makes us skeptical of the consensus expectation that operating margins will rise across the S&P 500 for the third year in a row. We think, at best, margins will remain at current levels.

As wage growth continues to accelerate, industries and stocks with low revenue per employee and low operating margins, and where top line growth could face pressure, are vulnerable to margin compression. Industries that fit the bill include consumer discretionary and staples, trucking and transportation, and healthcare services. We are cautious on these sectors into 2019.

Line chart compares the wage diffusion index and average hourly earnings from October 2000 to October 2018. The chart shows that these two factors are correlated; and as hourly earnings increase, so does the wage diffusion index.

Tactical crash protection will likely be needed due to volatility and thin liquidity

Our Economics team sees recession probabilities rising in 2020, and we expect 2019 equity returns to be challenged by peaking profits and fading fiscal and monetary accommodation concerns. Trade issues are still outstanding, and the degree to which the Fed will tighten is uncertain (the markets price in no rate hikes this year, while we foresee two). Therefore, conversations about portfolio crash protection should be timely.

What’s more, the market’s microstructure changed in many ways following the Global Financial Crisis. For example, dealers must carry less risk due to new regulations, and there are now 13 exchanges operating in the United States. The “flash crashes” and illiquid trading seen during 2018 drawdowns show how liquidity can evaporate as volatility rises at the very same time as the demand for instantaneous liquidity from markets participants such as Commodity Trading Advisors (CTAs), risk parity funds and quant funds increases. This dynamic can exacerbate the moves to the downside.

Owning equity index crash protection can help insulate portfolios during these episodes, and it can act as an added buffer should the market begin to price in the rising risks that will be associated with the next recession. Alternatively, should the Fed pause its rate hiking cycle or should the markets pull forward recession expectations, we expect U.S. long-term rates to rally. Given the low implied volatility on U.S. Treasury ETFs, buying upside optionality on longer-dated Treasuries could also provide portfolio protection.

Line chart compares the S&P 500 Emini Market Depth (a measure of market liquidity) to the VIX (a measure of market volatility) from January 2015 to July 2018. This chart highlights that when market liquidity is low, historically, market volatility has been high.

China’s infrastructure growth should increase

China’s economy is starting the year on a sluggish note. We expect the property market to continue to slow, trade tensions with the United States to weigh on sentiment, and consumer growth could be slow to rebound, given the buildup in consumer leverage and slowing wage growth. All of this could lead to further downside EPS revisions for China in 2019.

However, we think the government will boost measures to cushion this slowdown, with personal and corporate tax cuts part of the effort. Importantly, we expect that infrastructure fixed asset investment, which perked up late in 2018, could rebound further, given the easing measures put in place, such as easier access to financing and faster project starts. Any such rebound, pro-growth measures or an unexpected resolution to U.S.-China trade tensions could be beneficial to deep-value cyclicals in China, and globally. This makes China our 2019 contrarian idea, and we prefer to use derivatives to express any directional views cost-efficiently.

Line chart compares year-over-year percent growth change across mining, infrastructure, manufacturing, real estate and utilities. The chart shows that since mid-2018, each of these sectors has trended upward.

Despite tech uncertainty, data privacy regulation and 5G should accelerate

Concerns over weaker foreign demand amid U.S. dollar strength and trade wars have weighed on the hardware and semiconductor industries, and we expect that to continue. Also, worry about slowing tech spending in 2019 has begun to weigh on technology more broadly. Gartner forecasts suggest tech spending may slow from a standout 4.5% growth rate in 2018 to a more subdued (and normal) 3.2% in 2019. That said, enterprise software is expected to grow at a robust 8.3% (down from 9.9% in 2018), and cloud software spending is pegged to grow at a 22% clip. So, clearly, areas of tech strength remain, and we see two in particular:

  • Data privacy protection: In spite of a split U.S. Congress, data privacy concerns are shared across the aisle. After years of data breaches and intense scrutiny of companies such as Facebook, Yahoo and Equifax, both Democrats and Republicans have expressed interest in taking action. With the passages of GDPR in Europe and the California Consumer Privacy Act in 2018, we believe new legislation to regulate data privacy in the United States is likely coming. Select software providers should benefit from this increased focus on consumer data privacy in the United States.
  • Buildout of 5G: Verizon already launched commercial 5G service in 2018 in four cities, and South Korea and Japan are expected to follow with commercial launches this year. Apple and Samsung are gearing up to launch 5G mobile phones by 2020. We expect 2019 to be the year that 5G buildout accelerates globally, with hardware and software players reaping the benefits.

Bar chart showing year-over-year growth rates across consumer security software, network security equipment, identity access management, integrated risk management, infrastructure protection, total security, security services, application security services, application security, other information security software, data security and cloud security. Cloud security towers over the other bars at 50.99%, far above the overall IT growth of ~4%.

We look forward to discussing these ideas with you in more detail in the weeks ahead. As always, thank you for your continued trust in and partnership with GIO. We stand ready to help you navigate these increasingly more complex and volatile markets, and wish you a prosperous and successful 2019.