Outlook January 2019: Prepare for heightened volatility in the coming year
- Higher interest rates, global trade tensions and excessive debt will fuel market volatility in 2019.
- Slowing economic growth in Europe and China will likely weigh on markets.
- Investors shouldn’t let short-term troubles derail their long-term investment plans.
After years of relatively smooth sailing in the financial markets, heightened volatility is rocking the boat once again. Stocks and bonds encountered a perfect storm in 2018 as rising U.S. interest rates, a brewing global trade war and high debt levels combined to hobble a long-running bull market. In the U.S. and abroad, investors should expect continued volatility ahead as these powerful trends continue to play out in 2019.
What’s driving higher levels of volatility? There are many factors, but the three T’s are among the most impactful: tightening monetary policy, trade tensions and too much debt. The U.S. Federal Reserve and other central banks are expected to gradually tighten in 2019. However, the pace of that tightening may be slower than previously expected due to slowing global growth, worsening trade relations and a sharp market selloff that began in October.
The Fed may raise rates anywhere from zero to three more times in 2019, depending on the tenor of U.S. economic data and general financial-market conditions. In addition, the European Central Bank may finally bring an end to its years-long experiment with negative interest rates, which should allow benchmark 10-year German bunds to rise quickly from current ultra-low levels around 0.3%.
These events will unfold at a time when government, corporate and consumer debt are all rising dramatically. That will have implications down the road as higher debt-service costs restrict the spending plans of households, companies and government agencies alike. It was one thing to borrow when rates were at historically low levels; it’s a whole different environment today.
At the same time, global trade has taken center stage as the U.S., China, Europe and others jockey for position in what may emerge as a new world order. It’s important to note that these trade skirmishes may continue for a long time, even if some agreements are resolved overnight in a tweet from the White House. It’s a highly fluid situation that we will monitor closely throughout the year.
U.S. equities have enjoyed a remarkable run-up since the depths of the global financial crisis in 2008-09. Bottom line: That run is unlikely to continue. Even with the recent selloff, U.S. equity valuations are relatively high compared to their own history and the rest of the world. Using history as a guide, as valuations rise, future returns tend to fall.
That’s why it’s important not to abandon international and emerging markets equities, which have lagged the U.S. but are offering significantly lower valuations. Non-U.S. equities are, in effect, “on sale” compared with roughly equivalent companies based in the U.S. — whether it’s Apple versus Samsung, Airbus versus Boeing, ExxonMobil versus Total, or any number of similar examples.
Investors may find another source of opportunity in traditional value-oriented stocks, which, much like non-U.S. stocks, have lagged the overall market in recent years. During periods of market declines, certain sectors tend to fare better than others — including sectors with companies that pay meaningful dividends. Consumer staples and utility stocks are classic dividend payers and should be part of a balanced, well-diversified portfolio.
When stocks come under pressure, you want bonds that can provide relative stability, a measure of income and diversification away from equities. While this approach is always a smart one, it’s even more so during a late-cycle economy. One way to get there is to upgrade your bond portfolio to help reduce credit risk.
U.S. corporate bond spreads — the gap between the yield on credit and Treasuries — have been narrow by historical standards. That means the compensation for taking on credit risk is relatively low, and the upside could be limited. In addition, nearly 50% of investment-grade corporate bonds are now BBB-rated. Unless credit valuations further ease, it’s unlikely to be a good time for investors to take on excessive credit risk.
In this environment, high-quality U.S. Treasury bonds appear more attractive. For investors looking to diversify income sources, high-income municipal bonds and emerging markets debt also may be worth a closer look.