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Market View

Following a tumultuous end to 2018, where do things stand with equities as the calendar flips to 2019?

 

In Brief:

  • The potential for strong U.S. equity returns in 2019 is supported by a relatively strong U.S. economic backdrop that suggests a recession is not imminent.
  • However, many of the same concerns that factored into the volatility at the end of 2018 remain present, including the potential for a slowdown in global growth.
  • In short, volatility is likely to remain present even if equities manage the double-digit return that earnings and multiples suggest they are capable of.

 

The relatively benign U.S. equity market (represented by the S&P 500® Index) of 2017 gave way to volatility in 2018 capped off by a historic collapse in the fourth quarter as the market reversed a 9% year-to-date gain (as of September 30, 2018) into a 7% loss by year end—marking its worst calendar year since the financial crisis in 2008-09.

With this dramatic end to 2018 now in the rear-view mirror, how does the equity market look as 2019 begins? The first week of the new year saw continued volatility. But a full measure of the market’s potential requires a look at a number of factors both within and outside the United States.

Multiples
After peaking at the end of 2017, the forward price–to-earnings (P/E ratio of the S&P 500) trended generally lower during the first three quarters of 2018, driven by strong corporate earnings growth. As volatility spiked in the fourth quarter, equity multiples compressed even further, falling to 15.4x forward earnings by the end of the year—below their 10-year average of 15.8x forward earnings. This drop marked the first time that the S&P 500 forward P/E ratio had fallen below 15.8x since early 2016—suggesting that there remains potential upside in equities if multiples normalize toward their long-term averages.

 

Chart 1. A Falling Forward P/E May Suggest a Potential Upside in U.S. Equities in 2019
S&P 500® Index forward price-to-earnings ratio versus 10-year average, January 2, 2009–January 2, 2018

Source: FactSet. Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Earnings
While 2018 saw a resumption of equity market volatility, underlying equity fundamentals remained quite strong. As of the end of December, estimates for fourth quarter earnings growth for the S&P 500 were 12.4%, which would make it five straight quarters of double-digit earnings growth. For the calendar year, corporate earnings are expected to have grown by 20.3%—the highest rate of earnings growth for the index since 2010. While the rate of earnings growth is expected to slow in 2019, initial estimates show corporate earnings growing at a rate of nearly 8%, which would mark the fifth best calendar year in the past 10 if it were to hold.

 

Chart 2. If Initial Estimates Hold, Corporate Earnings Could Grow at a Rate of Nearly 8% in 2019
S&P 500® Index earnings and revenue growth, calendar years 2010-2019*

Source: FactSet. *Earnings and revenue growth for 2018 and 2019 are estimates as of January 3, 2019.  Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

What is particularly encouraging is that these initial estimates project the potential for positive earnings growth from every sector in the S&P 500, suggesting that there remains broad opportunity for investors across the market.

 

Chart 3. Initial Estimates Project the Potential for Positive Earnings Growth Across Sectors
S&P 500® Index projected earnings growth, calendar year 2019 estimates as of January 3, 2019

Source: FactSet. Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Macro Backdrop
Much like corporate earnings, U.S. economic fundamentals also remain fairly supportive of equities, and don’t suggest an imminent recession as some believe the market’s fourth quarter swoon may have implied. U.S gross domestic product (GDP) grew by 4.2% during the second quarter of 2018, its fastest rate in five years, and followed that up by a 3.5% growth rate in the third quarter. Full-year 2018 estimates have the economy on track to grow by roughly 3%. While this rate of growth is expected to slow during the course of 2019 as the stimulative effects of tax reform roll off, initial estimates have the economy growing at 2.6% -- above the long-term trend rate of roughly 2%. In addition, U.S. consumer confidence remains strong, reaching an 18-year high in October, and U.S. unemployment dropped to a 50-year low at 3.7%.

Outside the United States, the picture is slightly less rosy. After global growth surprised to the upside in 2017, global macro conditions disappointed in 2018—leading the International Monetary Fund (IMF) to cut their global growth forecast from 3.9% to 3.7% for the year. Looking forward, the IMF expects global growth to hold steady at 3.7% in 2019; however, risks remain. In particular, spill-over effects from an escalating trade war between the United States and China have the potential to grind global trade lower, while headline risks in Europe (notably the ongoing Brexit saga) have the potential to add to volatility.

China
And of course, no discussion of the global macro backdrop would be complete without addressing China. The year 2019 began with a rude awakening in the form of disappointing Chinese manufacturing data, with Chinese manufacturing (as measured by the Purchasing Managers Index or PMI) falling into contraction territory in December  2018—the first time since 2017. While that June 2017 reading was just a one-month blip, what investors will be most fearful of is a prolonged period of Chinese growth concerns similar to the late 2015 and early 2016 period, when Chinese manufacturing PMI consistently fell into contractionary territory. While an escalation of the trade war with the United States would certainly continue to weigh on Chinese economic growth, there are some encouraging signs in the non-manufacturing sector of China’s economy, which continued to expand in December even as Chinese manufacturing faltered. With China news moving markets on a seemingly daily basis, a resolution to the U.S./China trade war and signs of Chinese economic stability in both its manufacturing and non-manufacturing sectors bears monitoring in 2019.

The Fed
After hiking its target interest rate four times in 2018, the Federal Reserve (Fed) offered slightly more dovish commentary in its statement following the meeting of the Federal Open Market Committee in December. While initial projections after the December meeting forecasted two additional rate increases in 2019, by the end of the month markets had begun to price in a likelihood of no additional rate hikes in the new year. With inflation slightly below the Fed’s 2% target and its target fed funds rate now at the lower-end of its neutral range (according to Fed Chairman Jerome Powell), monetary tightening may not present the same headwinds it did in 2018 when the Fed remained steadfast in its commitment to normalize rates at a consistent measured pace. In fact, the market responded positively on Friday (January 4, 2019) when Powell cited muted inflation readings, signaling that the Fed intends to be flexible rather than follow a preset plan for interest-rate hikes.   

President Trump
While the first year of the Trump presidency saw the Republican-controlled government enact a number of market friendly policies (including tax reform and broad deregulation), the second year saw some of the less market friendly policies of the Trump platform come to the forefront. Escalating trade rhetoric with long-standing partners was a key theme throughout 2018, and while a new trade agreement between the United States, Mexico, and Canada was ultimately reached in the second half of the year, there has yet to be any resolution to the trade war between the United States and China. In addition, continued focus on border security led to a government shutdown in December (with no resolution as of the start of 2019). With Democrats gaining control of the House during the midterm elections, there is the potential for the next two years to be characterized by political gridlock, with headlines (rather than policy) moving markets.

What does this all mean?
In sum, there are a lot of moving parts for equity investors to consider in 2019. With corporate earnings expected to grow at a nearly 8% pace next year and equity valuations below their long-term averages, we believe there is a solid foundation in place for strong equity returns in 2019. This is supported by a relatively strong economic backdrop that suggests a recession is not imminent, particularly in the United States. 

However, many of the same concerns that factored into the volatility at the end of 2018 remain present, including the potential for a slowdown in Chinese growth (and relatedly a slowdown in global growth), further political turmoil in the United States, and the risk that a spike in inflation could force the Fed into a more aggressive monetary posture than the market is assuming today.

In short, volatility is likely to remain present even if equities manage the double-digit return that earnings and multiples suggest they are capable of. In a volatile, late-cycle environment such as 2019 may be, it is imperative that equity investors be discerning as not only does growth become more scarce but also the absence of monetary or fiscal stimulus has the potential to lead to a larger bifurcation of winners and losers than has been experienced in recent years.

 

A Note about Risk:  The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. All investments involve risks, including the loss of principal invested.

Glossary of Terms

Federal funds rate (fed funds rate) is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight. 

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.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

This material is provided for general and educational purposes only. The examples provided are for illustrative purposes only, and are not indicative of any particular investor situation.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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