February 28, 2019
Paul Christopher, CFA, Head of Global Market Strategy
Darrell L. Cronk, CFA, President of Wells Fargo Investment Institute
Keeping Fingers on the Pulse of the Markets
- This year’s market rally (to-date) has rested on pricing out recession fears, rather than pricing in broad global economic improvement. However, the opportunities this year are likely to depend upon how the economic uncertainties resolve in the coming weeks and months.
- As these inflection points turn into new market trends, we believe investors will need to be ready to adjust their portfolios.
What it may mean for investors
- We still have a favorable view of most equity markets as well as short-term and high-quality fixed income. We are less favorable on markets at risk from the global economic slowdown. As the economic data improve, we could favor taking more risk again in portfolios, but now is the time to keep one’s fingers on the pulse of the market.
In late February, the S&P 500 Index is close to our year-end target and probably reflects relief over fading recession fears. In December, we noted that the economic data did not support so much pessimism, and we still foresee an eventual recovery in economic growth. Yet, the past few months have been extremely volatile, and equity and bond prices have moved from extremely oversold conditions in December to mildly overbought in February. The likely financial market drivers during the coming quarters do not argue for investors to be defensive in their portfolios. Instead, we believe these drivers suggest a pause or consolidation in the recent uptrends in many risk assets (e.g., equity and commodity prices) and a lowering in bond yields.
As investors consider next steps, we believe it is important to keep an eye on the following market uncertainties:
- Monetary policy reversals: In January, the Federal Reserve (Fed) initiated a pause in interest rate hikes. Other central banks are also moving towards easier monetary conditions, and this trend has helped fuel the latest rally in risk assets, such as equities and some commodities. We continue to believe that U.S. policymakers will hike rates at least once in 2019, even as market expectations now predict no rate hikes. Some volatility is likely if the Fed decides to correct market expectations.
- The political calendar: Political questions also have driven some recent optimism, but we are more cautious. A strong majority opinion in the U.K. Parliament opposes a no-deal divorce from the European Union, but the only other deal in discussion is the one parliament already rejected twice. We find neither option appealing for investors. A 60-day extension is possible before the March 29 deadline, but it is unclear how or if parliament will consider any other options. Meanwhile, the U.S. and China have extended their trade negotiations. We still expect a long-term deal, but the main issues are complex and unlikely to be resolved soon. More disappointment is likely if both the Brexit and the U.S.-China trade negotiations drag out into mid-year without clear goals.
- A fluid picture for economic and earnings growth: We do not foresee a 2019 U.S. economic recession. The U.S. labor market remains strong. Monetary and fiscal policies should support credit flows and corporate liquidity. However, the global economy has not finished its third sustained slowdown of this expansion (the other two happened in 2011 and in 2015-2016). Europe’s economy is still weakening, and China’s stimulus measures seem calculated to stabilize—but not raise growth. The sluggish international economy has weighed on U.S. core capital goods orders (since April 2018) and factory output (since September 2018).1 The deteriorating global economic outlook supports the U.S. dollar, making another potential headwind for U.S. earnings. At this point, expectations for U.S. earnings indicate a flat first half and then recovery, but full-year forecasts may revise lower if the global slowdown persists. We believe a realignment between market movements and fundamentals is coming.
How might investors approach this time?
This year’s rallies in global equities and in some commodities have rested on pricing out recession fears, rather than pricing in broad improvement. Such is the nature of retracements after indiscriminate sell-offs, but attention should be paid as many markets have reached important inflection points—levels from which prices could pivot higher or lower. Ultimately, the trends and investment opportunities this year are likely to depend upon how the economic uncertainties resolve in the coming weeks and months.
As the inflection points turn into new market trends, we believe investors may need to be ready to adjust their portfolios. We still have a favorable view of most equity markets, including U.S. large- and mid-cap equities, but we recently reduced exposure to small-cap equities as a way to reduce risk. Likewise, in fixed income securities, we prefer short- over longer-term securities and investment-grade over lower-rated credits. If the economic data continue to worsen, we may find other opportunities to move portfolios away from economic risk; if the data does improve, we may favor taking more risk in equities. Now is not the time to be drawn in by complacency but to keep one’s fingers on the pulse of the market.
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