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Equity Perspectives

In this podcast, product strategist Trent Houston talks about the factors expected to drive equities in the New Year.

Transcript

PODCAST 2019 Equity Outlook

The Investment Conversation: Surveying the Stock Market as 2019 Begins

In this podcast, product strategist Trent Houston talks about the factors expected to drive equities in the New Year.

VO: Welcome to The Investment Conversation, Lord Abbett’s ongoing podcast series.

Will Andrews: This is Will Andrews, Digital Content Editor for lordabbett.com. I'm joined today by Lord Abbett Product Strategist Trent Houston, who specializes in equities. Trent, as 2019 begins, the U.S. stock market is being driven, some might say driven crazy given recent volatility, by a number of domestic and global factors.

You've outlined some of these factors in the January 7, 2019, Market View entitled, "Taking Stock of the Equity Market," which can be found online at www.lordabbett.com/marketview. Can you give us some background on a few of the major drivers discussed in the article? Let's start with the state of U.S. corporate earnings and how that's filtered through stock valuations.

Trent Houston: One thing we've seen obviously alongside the volatility that we've experienced in the fourth quarter of 2018 was equity valuations that have compressed to their most attractive levels in near three years. When we're looking at forward-priced-to-earnings ratio in the S&P 500.

And by forward-priced-to-earnings ratio, we're talking about the price of the S&P 500 divided by the estimated future earnings per share of the constituents. What we are seeing is that the long-term average P/E is about roughly 15.8 times forward earnings on the index. We were at 15.4 times as of the end of December 2018. That's the lowest level we experienced since early 2016. You combine that with fairly optimistic earnings projections—while we're expected to slow somewhat off a very strong 2018, in which we saw projected 20% earnings growth year-over-year. In 2019, we're still expecting to see further growth even as it slows somewhat--about 8% year-over-year. That still would make it the fifth best calendar year in the last 10 years.

Andrews: Trent, what factors will cause the slowing? A fall-off in terms of the stimulus from the tax reform package, for example?

Houston: That certainly one element of it. The tax reform, fiscal stimulus, definitely was a robust tailwind to corporate earnings in 2018. Again, what you're having here as well is the higher base to grow off of. So you're expected to see further growth.

It's tough to replicate year-over-year double-digit sales growth like we saw at the end of 2016 and throughout 2017 into 2018. It's not unexpected that as you enter the end of an economic cycle, the end of a business cycle, that earnings slow somewhat. We're still expecting to see that growth, of course, but it does seem like the earnings cycle peaked in 2018 and we're going to come down a little bit as we enter 2019.

Andrews: Another big concern for investors is global economic growth, especially the prospect of a slowdown in China. Indeed, we've been seeing some headlines on that recently. Now how might that impact the market in the coming year?

Houston: It's definitely the key consideration if you followed the market gyrations over the last three months. And even so far into 2019, it seems that China news is the real driver of the market. And as we started 2019, we saw right off the bat a disappointing P.M.I. reading from Chinese manufacturing, followed by a revenue guidance cut from Apple, which was partially blamed on limited demand in China. Those two things spooked the markets a little bit. If you take a bigger picture view, of course, the trade concerns with China continue to weigh on uncertainty with regards to growth in that market.

And when China catches a cold, the rest of the world tends to get sick. We saw something along these lines happen in late 2015 and 2016. So it certainly bears monitoring, but there are encouraging signs as well. China's been engaged in a program to really focus on diversifying its business sectors away from just purely manufacturing. And while the P.M.I. from manufacturing did contract for the first time since 2017, in December of 2018, you did not see that follow suit in the non-manufacturing sectors. They continue to expand.

So there are some positive signs as China diversifies its economy. While manufacturing may falter a little bit, the rest of the economy has remained relatively strong. But of course, it bears monitoring as we move forward. In addition, outside of China, we saw the IMF ratchet down its global growth expectations in mid-2018 from what was a 3.9% projection to 3.7%.

We're expecting 3.7% again for 2019. So, a relatively flat year in terms of year-over-year projections. Not much acceleration. But there are things that bear monitoring as well: how does Brexit turn out, as well as some other political considerations in both the United States and Europe.

Andrews: Another factor that springs to mind when we discuss China is the current trade standoff it's experiencing with the United States. Any thoughts about the impact of that and what it could mean for equities in the coming months?

Houston: Today [January 7, 2019], when there [was] some positive trade news around China, the beginning of some trade negotiations, the market responded fairly positively. So it understands that the trade uncertainty could certainly have an impact on [the] global economy, and corporate earnings in particular.

When you think about it, if China slows, that could be a cut to everyone's earnings. And all of a sudden, those attractive multiples that we talked at the outset here are no longer necessarily below average. We see earnings cuts continue to come down and that takes a little bit of the shine off the market in terms of how attractively valued it is today. So it's certainly something that is being watched. What I think, broadly throughout the markets, is that if global growth does slow, presumably as a result of trade wars--whether that be with China and the U.S. or Europe and the U.S.--whatever it may be, you're going to see a potential for corporate earnings to continue to slowly ratchet down the expectations. I should say, for corporate earnings, ratchet down through the course of the year.

Andrews: And I guess finally, we’ll wrap up the main topics that you covered in the Market View this week. Certainly, one that we can't stop talking about: the [U.S.] Federal Reserve [(Fed)], and whether it's going to continue on a more dovish path. Is it going to stay hawkish? What are the considerations here as we enter the New Year?

Houston: [Fed policy] certainly seems to be one of the contributors to the volatility in December. Was the Fed going to continue with its preordained rate hike throughout 2018, and [hike] one last time? But as the Fed came out with its comment, and you heard from Chairman [Jerome] Powell after that rate hike, it became clear that they weren't going to follow such a preset, measured type of pace in 2019. Immediately following the meeting, when Powell said that we were at the lower end of the neutral bound, the market ratcheted down expectations for rate hikes in 2019 from three to two.

Volatility persisted throughout the rest of December. As we began 2019, you saw the market begin to price in no rate hikes. And then on Friday [January 4, 2019], we heard Chairman Powell speak again. And again, in very dovish tones, speaking to the understanding of being a little more flexible with policy in regards to market conditions. And the market responded very favorably to that tone.

So now you see a market that's projecting, you know, a little headwind in terms of rate hikes moving forward. The potential even for accommodative policy in 2019. And the thing that really bears monitoring would be, of course, inflation. As the market is pricing in a more dovish posture from the Fed, a spike in inflation, whether that be from a wage inflation scare.

We've seen unemployment now at 50-year low in the U.S. An oil price shock, things of that nature has the potential to reset the Fed posture. And of course, as we are expecting, a fairly accommodative to neutral Fed in 2019. Anything that ratchets up expectations of a more hawkish Fed will be perceived as a negative for the market.

And it's important to keep in mind that while we talk a lot about the Fed here, is has been the first central bank to embark on a tightening cycle post the financial crisis. The muted global growth and some disappointing [economic data] numbers around the world mean that you're probably going to get fairly accommodative to neutral policy broadly from central banks.

So that's not just the United States, but in Europe as well as Japan. The expectation is across the board [is that] we should see monetary policy as neutral to a tailwind in 2019.

Andrews: Well, from corporate earnings, to China, to central bank policy, we certainly have a lot to think about this year. What's a key takeaway from all of this? Readers of your Market View, what should they be thinking about with all of these conditions,- relative to their equity portfolios?

Houston: It's certainly not an easy task. And I sympathize with people who are trying to fight through all of the conflicting noise here in the markets. But if you take a 10,000-foot overview, on the surface this does seem to be the most attractively valued equity market we've seen since early 2016, which of course [was the start of] a two-and-a-half-year strong bull market in equities.

The risks are high and there's no doubt about that, whether it be China or the potential for a more hawkish Fed than we've expected. Even political developments here in the United States. Now that you have a Congress that's split between the Democrat-controlled House and the Republican-controlled Senate, that could lead to gridlock. There's still no clear resolution on Brexit.

There remain a lot of risks in the market and the headlines, even though if you [may] take that really fundamental view and you say, 8% earnings growth, attractive valuations. That sets up well for a pretty positive year for equity investors, assuming that none of the real worst-case scenario risks come to fruition. But as we saw in December and we have seen even to start this year, given the elevated risks in the market, it's not unreasonable to expect continued volatility out there.

And with the lack of monetary stimulus that we saw in the first half of this decade and the fiscal stimulus that we saw from the tax cuts, you might see a great bifurcation, a great difference between the winners and losers in this market alongside increased volatility. It makes it a much more difficult market to navigate. And again, it speaks to a situation where investors have to be discerning in their equity investments in 2019.

Andrews: Well, you've certainly given us a lot of food for thought here, Trent. Once again, readers can view the complete article entitled, "Taking Stock of the Equity Market," at lordabbett.com/marketview. Thanks for listening.

VO: That’s it for this edition of The Investment Conversation. As always, you can access a full range of investment commentary and analysis at lordabbett.com. Thanks for listening.

IMPORTANT INFORMATION

IMF refers to the International Monetary Fund.

PMI refers to purchasing managers index.

Forward Price-to-Earnings Ratio: Stock analysts calculate a forward price-to-earnings (P/E) ratio by dividing a stock's current price by estimated future earnings per share. Some forward P/Es are calculated based on estimated earnings for the next four quarters, while others use actual earnings from the past two quarters with estimated earnings for the next two. A forward P/E may help you evaluate the current price of a stock in relation to what you can reasonably expect to happen in the near future. In contrast, a trailing P/E is based exclusively on past performance.

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