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Market View

In the first of a three-part series, Lord Abbett investment leaders analyze the factors that drove the market in 2018, and that may influence investments in the coming year.

 

In Brief

  • Once again, we convened five Lord Abbett investment leaders for a roundtable discussion, this time to discuss the investing environment of 2018, the outlook for 2019, and strategies for the coming year.
  • Our panel represents a wide range of our firm’s investment disciplines: multi-asset strategies, U.S. equities, U.S. taxable fixed income, emerging markets, and municipal bonds.
  • In the first installment of our three-part series, our experts explore how developments in corporate earnings, trade, and interest-rate moves influenced key investment categories in 2018.

 

The year 2018 has not lacked for interesting storylines for the global economy and markets. Investor optimism in the spring and summer—spurred by strong corporate profits, restrained inflation, and continued global growth—gave way to caution in the historically volatile month of October.

What were the likely reasons? Investors began to fret that company earnings would decelerate, with increased trade friction between the United States and China adding a strong headwind. Fears that the U.S. Federal Reserve (Fed) would hike rates too rapidly also factored into the sentiment shift. The market gyrations continued into November, and had, as of November 30, resulted in negative year-to-date returns for most of the major U.S. asset classes. As one Lord Abbett investment professional put it, the gloom reached a point where it appeared that investors, suddenly wary of slowing or negative growth, were “wandering around waiting for the end of days.”

Of course, no one is recommending that investors begin stocking up on dehydrated food and bottled water. Perhaps a pullback was inevitable, given the ebullience that characterized much of the year. We believe that understanding the factors that influenced the economy and markets in 2018 is an important first step in formulating views about where things may be headed in 2019.

As we did at midyear, we gathered five Lord Abbett investment leaders in late November for a wide-ranging discussion of the current market and economic environment and their views on key investment themes for the coming year. In this, the first of a special three-part Market View, our panel examines the factors that influenced key asset classes and economies in 2018. Part two will focus on their expectations for the environment in the year ahead. In the concluding segment, our experts will discuss how the factors outlined in parts one and two inform investment strategies for key asset classes.

Once again, 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; and Kewjin Yuoh, portfolio manager for taxable fixed income. For the new edition, the panel welcomed Leah Traub, partner and portfolio manager for taxable fixed income. The discussion was moderated by Joseph Graham, head of the firm’s investment strategy group. (Coming soon: Visitors to lordabbett.com will be able to access a full range of content from the panel discussion.)

The Big Picture
In our July 9 outlook, the panel acknowledged favorable global economic conditions; however, the year-end assessment was more muted. Martini noted two different “strands” of policy and politics influencing the economy and the markets in 2018. The first: The 2017 U.S. tax reform package, along with the Trump administration’s push for deregulation. Those factors were positive for economic growth, and thus, corporate profits, according to Martini. 

The second strand, which had to do with the administration’s hardline approach to trade and immigration, was “always clearly going to be negative” for the market, economic growth, and corporate earnings, said Martini, “and I think we've turned around to focus more on that second part right now.” And with a few signs of slowing in the global economy underscoring the existing uncertainty, especially regarding U.S.-China trade tensions, “I think investors have really started to worry about how this all could come together and develop over the next year or so.” The gloom makes it seem as though investors are “kind of wandering around waiting for the end of days.”

At some point, Martini notes, a downturn will come. But before that day comes, the current U.S. business expansion is poised to become the longest ever in U.S. history (see Chart 1). Nonetheless, Martini thinks that investors have started to “really worry about” the potential for slowing economic growth to weigh on corporate earnings.
 

Chart 1. Will the Current U.S. Expansion Break the Longevity Record?
Length (in months) of U.S. economic expansions for indicated periods

Source: National Bureau of Economic Research. Data as of October 31, 2018.

 

But the “end of days” would be triggered by stresses that bring an end to the conditions that allow the economy to grow and the markets to move higher, according to Martini. With inflation remaining at low levels, and in the absence of credit bubbles or other market distortions, “we just don't see” those stresses, Martini said. “So this could not only end up being the longest U.S. economic expansion, but it could far outpace the previous record.”

Taxable Fixed Income
Graham steered the conversation toward the U.S. bond market with a question for Yuoh, who noted “a sense of déjà vu" from the last time the panel gathered. “Things were weakening a little bit,” Yuoh recalled, “and the narrative in the markets at that time seemed to be that the yield curve was flattening.” There was a widespread narrative that held that if the curve inverted, a recession would follow, with a negative impact on prices of risk assets, according to Yuoh.

Fast forward to late November, and as Yuoh noted, “the yield curve is actually flatter now than it was when we last met—and that narrative is completely gone.” Where did it go?

“We came into the third quarter believing that this time it was different, that the flat yield curve was okay,” said Yuoh. “And in the third quarter, risk assets seemed to agree with us,” as they performed well. The fundamentals of the economy remained favorable, in investors’ view. But “all of a sudden, we hit the fourth quarter and the narrative became, ‘we can't handle rising rates’,” Yuoh observed. Investors’ worries centered around the policy path of the Fed, and whether the central bank was hiking rates too fast, and by too much. The fear of higher rates seemed to be one of the main storylines for the weakness in the U.S. bond market in the fourth quarter.

But Yuoh disagrees with that focus. “How is that so different from what we've been experiencing the last few years in terms of the Fed raising rates 25 basis points every quarter, with the expectation that they're going to continue to do so, especially with fundamentals so strong—and inflation so tame?” These conditions give the Fed additional room to remove accommodation, according to Yuoh.  

Yuoh believes the signal moment for the bond market in the third quarter may have occurred at the end of the September Federal Open Market Committee meeting, when a statement from Fed officials removed the word “accommodative” in describing policy, and started pointing towards a greater emphasis on data dependency. “I think that should have signaled to the markets that we are due for higher volatility because of higher uncertainty,” Yuoh said. “And when you have higher uncertainty, you should have higher risk premiums.” That, according to Yuoh, has been the main influence for the direction of the fixed income market in late 2018.

Emerging Markets
Graham posed a question to Traub about the current environment for emerging market (EM) investments, especially given the strengthening U.S. dollar.

Traub pointed to a combination of factors. The Fed’s three rate hikes through September reduced liquidity. The increasingly heated trade squabbles between the United States and China began to command investor attention. Finally, signs of an emerging slowdown in China—a huge influence on many other emerging economies—weighed on sentiment. These factors, Traub noted, also had a negative effect on prices of commodities, a key output for many emerging market economies.

The woes were exacerbated by an extended rise in the value of the U.S. dollar versus other currencies, starting in April and continuing into the summer. The volatility experienced by emerging markets eventually broadened out into developed markets, giving EM investors “a little bit of a reprieve.”

“I do think the volatility is still going to be with us,” Traub said. The key factor is a lack of clarity on U.S.-China trade tensions, and “I don't think we're going to get a quick or a full resolution,” she added. Traub sees the possibility of smaller trade deals, but absent a definitive conclusion to the dispute, she thinks the situation will “ebb and flow and be with us for a while.”

U.S. Equities
The discussion turned to the U.S. equity market in 2018, with a focus on O’Halloran’s specialty, growth stocks. Graham asked if the trade tension referenced by Traub was a factor behind the late-year weakness, which involved an investor rotation out of many growth names into other sectors of the market.

O’Halloran believed the Fed’s ongoing moves to reduce its balance sheet and raise interest rates had a greater impact than trade issues. “But they're both at work in bringing about the corrective phase that we find ourselves in right now,” he said. O’Halloran noted that growth stocks had led the market for nearly 21 months. And after such a stretch, “they tend to go through a corrective phase for some period of time, which is clearly what's happening now.” He observed that the leadership of the equity markets has changed from the big-cap tech “FAANG” stocks to some defensive areas, such as utilities and consumer staples.

“So we are currently in a corrective phase,” O’Halloran concluded. He harked back to the market risks listed in the June roundtable—such as the flattening yield curve, trade, and geopolitical tensions—which investors had brushed aside as they bid equities higher during the summer. “They finally came to matter” in October, he said.

Municipal Bonds
Graham asked Solender to frame the municipal bond market environment in 2018.  Solender noted that the factors contributing to a “slightly negative” year for the overall muni market include the Fed’s policy moves and strong U.S. economic growth, and their joint impact on interest rates. Another, overhanging factor has been the U.S. tax legislation enacted in December 2017. All of these developments have had an impact on municipal bond valuations while the fiscal situation for state and local governments has remained strong.

Retail investors, who make up the majority of the muni-bond market, remain “very concerned” about rising rates, noted Solender. This has reduced their demand for longer-dated munis and spurred buying in the shorter end of the market. To the surprise of many, Solender added, the muni yield curve has steepened even as the Treasury curve has been flattening. The curve steepening in munis in 2018 reflects the supply and demand dynamics from all types of investors.

As Solender has noted on a number of occasions, uncertainties about the final shape of the U.S. the tax bill pushed the issuance of many bonds that would have been brought to market in 2018 into December of last year. Thus, “the first half of 2018 was really slow in terms of supply,” while things picked up somewhat later in the year. Even though the overall fiscal situation for U.S. state and local governments remains favorable, “states and municipalities have been holding back a little bit on borrowing,” which has been a positive in terms of supply. Weighing on the demand side has been the reduced presence of banks and insurance companies in the muni-bond market, as lower corporate tax rates from the 2017 bill have reduced the attractiveness of tax-free securities for these buyers.

Solender summarized the mixed 2018 environment. “Fiscally, things are doing very well,” with most states seeing improved revenues. He noted that the overall credit quality of muni issuers remained strong. But rising rates and the steepening muni curve have led to the investment-grade market being slightly negative for the year, while the lower-quality segment of the market has turned in a positive performance.             

Looking Ahead
As our panelists observed, the markets faced a variety of challenges in 2018, many of which are poised to continue into 2019. But one common theme did emerge: Martini, Yuoh, and Traub emphasized that economic fundamentals in the United States remain solid, while Solender noted the overall fiscal health of muni-bond issuers. How might this strength factor into the outlook for 2019? We’ll explore that and other topics in the next Market View

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

Webinar Replay: 2019 Outlook
video
Listen to a replay of our Jan. 2 discussion with our investment leaders about their 2019 outlook for the economy, fixed income, and equities markets.

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