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Market View

In the second of a three-part series, Lord Abbett investment leaders assess the backdrop for the coming year, including prospects for monetary policy and economic growth. 

 

In Brief

  • In the previous Market View, we looked at the factors influencing markets and economies in 2018. But what about the environment for 2019?
  • Here, we continue our roundtable with Lord Abbett investment experts—representing a range of multi-asset, fixed income, and equity disciplines—about the backdrop for the coming year.
  • Their responses centered on potential policy moves by the U.S. Federal Reserve and other central banks, as well as prospects for the longevity of the current U.S. economic cycle.

 

On November 27, we gathered five Lord Abbett investment leaders for a wide-ranging discussion about their expectations for the economy, markets, and investments in the coming year. Last week, in the first of a special three-part Market View, they reviewed the factors that influenced the market and economic environment for 2018. Taking the past as prologue, this second installment focuses on how these factors could set the macro backdrop for 2019, with a special emphasis on monetary policy. In the concluding segment, our experts will discuss how the conditions outlined in parts one and two inform investment strategies for key asset classes in 2019.

Our panel featured Lord Abbett partners Giulio Martini, director of global asset allocation; Thomas O'Halloran, portfolio manager for micro-, small-, and large-cap growth strategies; Daniel Solender, director of tax-free fixed income; Leah Traub, portfolio manager for taxable fixed income; and Kewjin Yuoh, portfolio manager for taxable fixed income. The discussion was moderated by Joseph Graham, head of the firm’s investment strategy group. (Visit our 2019 Investment Outlook page to access a full range of content from the panel discussion.)

Rate Expectations
Concerns about the U.S. Federal Reserve’s (Fed) efforts to normalize monetary policy—as it winds down an unprecedented multiyear quantitative easing program—dominated the market in 2018, and appear likely to do the same in the coming year. Graham asked Traub if she expected continued rate hikes in the United States in 2019, or if policymakers take a pause in light of resurgent market volatility.

“Based on the economic fundamental outlook, [things look] pretty strong” in the United States, said Traub. “I think growth is decelerating a little bit” from its peak in the second and third quarters of 2018, “but it still will be relatively strong.” She noted that inflation remains near the Fed’s target of 2%. Thus, “I think the Fed can hike a couple more times.”

Traub said the Fed’s “dot plot” depiction of policymakers’ future expectations for the fed funds rate released in September showed a median expectation of three more rate hikes next year. But given recent volatility in stocks and bonds, “the market has certainly moved to discount that.” (See Chart 1.)

 

Chart 1. Sorry, Fed, the Market Has Its Own Ideas about Monetary Policy in 2019
Probability of at least two U.S. Federal Reserve rate hikes in 2019 based on fed funds futures, May 29, 2018–December 10, 2018

Source: Bloomberg.
The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator or a guarantee of future results.

 

With the Fed paying more attention to global economic conditions, policymakers may be looking for growth outside the United States “to rebound a little bit,” says Traub. “But if we don't see that, and we see continued weakness [in other economies], I think the Fed may take a pause, or move more slowly.”

What about policy moves by other central banks? Traub noted that the European Central Bank (ECB) and the Bank of Japan (BoJ) are at different phases of their quantitative easing programs. “Obviously the BoJ is still actively involved, but the ECB should [end its asset purchases] by the end of this year.” But, she noted, the ECB will not be in a position to wind down its asset portfolio the way the Fed is doing. “It’s going to be a long time before either the ECB or BoJ is able to get to where the Fed is,” she said. Thus, the developed world’s three major central banks will remain on divergent policy paths in 2019.

The Main Event
Graham noted the presence of “other X factors” that could influence Fed policy, like the uncertainty surrounding U.K. lawmakers’ efforts to implement Brexit and the ongoing budget difficulties in Italy.

Martini said “the market priced in” a Brexit-related slowdown in U.K. economic growth, along with a move lower in the pound versus other currencies, immediately after the vote to leave the European Union was taken in June 2016. He noted that Italy’s budget situation “has actually been showing signs of improving.” He cited a recent survey of attitudes in Italy toward the euro that showed a large increase in support for staying in the common currency, and a significant decline in opposition. “I think that's really a signal to the Italian government that it needs to conform its policies in a way that's acceptable to the other members of the eurozone,” Martini added.

“But I think those ultimately are sideshows to the main event, which really is the Fed,” Martini said. He noted a key difference in the current environment from previous Fed tightening regimes: “We know that the Fed can tighten and still have the economy and the markets do well.” The Fed’s intent to normalize policy has been well known, and widely communicated, over the past several years. Martini said the central bank first signaled a change in policy in 2013, and implemented the first of nine interest-rate hikes at the end of 2015, “and we've had very strong markets and a strong economy since then.”

Martini said that now, investors are uncertain what the “trigger point” for moving into a restrictive rate environment would be. He cited the concept of the natural rate of interest, the interest rate at which the economy can grow at its long-term trend with stable inflation. A widely held view has the natural rate at around 3%. “Up until now, the Fed has really tightened in an environment where fed funds have been well below what's thought to be the natural rate. But now we're getting closer.” Should investors perceive that a future tightening move takes rates above that level, the economy would start to struggle to maintain its current growth rate. And at that point, “the markets would have a problem dealing with that.”

Cycle Turn?
Graham noted that investors he has spoken with are concerned that the U.S. is in the late point in the current economic cycle, “that we have an impending recession ahead simply because that's the natural way of things,” and that financial leverage has built up to an excessive degree. He asked Yuoh for his thoughts.

“The late-cycle argument has been around for several years,” Yuoh answered, with proponents arguing that the U.S. is in “the seventh or eighth inning” of the current expansion. “We've been pushing back, suggesting that we've been more mid-cycle, if you look at the economic data.” Yuoh thinks investment-grade leverage has “flattened out and plateaued” over the last 18 months.

Yuoh expanded on that thought. “Ever since Dodd-Frank and all of the regulations” imposed on the U.S. financial system in the wake of the 2008–09 crisis, “leverage has decreased and underwriting has improved,” Yuoh said. Referencing Martini’s earlier comments about identifying imbalances in financial markets, Yuoh said “we don't see” stresses in securitized fixed-income products, nor within corporate leverage. Although leverage remains high, companies’ financial wherewithal to cover interest costs “remains reasonable.”

“So if you think about where we are in the cycle, if you look at the data, including ‘soft’ economic indicators such as consumer confidence and purchasing manager sentiment, they are all very strong, and have been on uptrends for the last six months.” Among “hard” economic data, recent reports signal continued strength in the U.S. labor market, while industrial production has been “reasonably” strong. Meanwhile, inflation remains moderate “and really presents no challenges right now.”

In thinking about the potential end of the current cycle, Yuoh said a comparison with early 2016 is telling. “We had oil shocks and China concerns,” much like today. “And at that time, if you looked at the economic indicators, they really were on a downturn for the previous seven to eight months. That's just not the case right now.” When might the current cycle end? Yuoh expects it will be a “protracted period of time” before that happens.

In a follow-up email, Yuoh provided Market View with an update on his view of the Fed’s potential policy moves for 2019. Given the current environment for the U.S. economy, inflation, and the trajectory of key economic indicators, he now expects three rate hikes from the Fed in in 2019.

Uncharted Waters
Turning to equities, Graham noted that while analyst forecasts continue to call for decent U.S. corporate earnings growth, “it seems like there is some skepticism built into the market.” He asked O’Halloran for his views.

“I think the market is concerned about the pace of Fed tightening,” O’Halloran said. “We're really in uncharted waters here… we have never had a monetary experiment like this in history.” He noted the expansion in the Fed’s balance sheet from $800 billion before the quantitative easing began in 2008 to $4.6 trillion at its peak. “And that was the fuel for the equity markets for most of the past 10 years.”

With that coming to an end, the pace of tightening will be a “very important” issue, said O’Halloran, one that will have a definite impact on the equity markets. “I think that the Fed is not going to raise rates as much as the market expects. I think that they will tap the brakes,” because additional tightening may further dampen already-weak equity market sentiment in the short term.

O’Halloran continues to be bullish on U.S. equities in the intermediate term. “As Kew and Giulio point out, there are reasons to continue to be optimistic about the health of the economy, and inflation is under control.” As he had previously noted, he believes the technology revolution will be “a very powerful and healthy force” for equities for decades to come.

O’Halloran acknowledged the “corrective phase” in U.S. equities, and “the technical damage that has been done” to certain stocks. And with investors favoring defensive names, he wonders whether this corrective phase “might have a little bit longer to go.” But looking through the balance of 2019, he continues to be “very optimistic.”

Spending Watch
Solender noted the importance of monitoring the Fed’s statements and actions, but pointed out other macro factors influencing the muni-bond market. “The story has really been more about inflation, growth, and the amount of [bond] issuance,” he said. “You have a [U.S.] Treasury that's issuing a lot of bonds right now.” That issuance, necessary to fund an expanding U.S. budget deficit, is “probably much more important than whether the Fed does two or four hikes next year,” because of the U.S. government’s increased funding requirements. “And revenues have to catch up to keep up with that.”

He noted that U.S. state and local revenues continue near record levels. At the same time, issuance of general obligation municipal bonds has not increased much. Meanwhile, “infrastructure spending is falling way behind in this country.” Eventually, the infrastructure deficiencies will need to be addressed by greatly increased spending along with borrowing, and “that could be a big number.”

Solender also believes that how federal, state, and local budgets are set will be critical in the coming year, since the fiscal health and budgetary discipline of issuers is essential to assessing their creditworthiness.

Looking Ahead
For investors, the confidence and animal spirits that characterized much of 2018 gave way to uncertainty and volatility by year-end. The effectiveness of central bankers’ moves to steer the economy through a tricky time will go a long way in determining the performance of key asset classes in 2019. In the final segment of our special Market View, we’ll look at how our investment leaders may approach portfolio decisions in the year to come. 

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

Webinar Replay: 2019 Outlook
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