With the 2018 mid-term election behind us, we wanted to take this opportunity to discuss the implications for both equity and fixed income markets moving forward.
The election came on the heels of an ugly October with many headlines of “Worst Month ….”. As discussed in previous communications, the drivers of weak performance included:
- Seasonal weakness of October, the last month of the historically weak summer period
- Uncertainty as to whether Democrats would take control of both the House and Senate in the mid-term elections
- Largely negative reaction to Q3 reported earnings and questions as to whether earnings are peaking for the current cycle
- A hawkish Fed intent on pushing rates higher – four rate increases this year after an expected hike in December with expectations currently for further hikes in March and June of 2019 (the market fears that the Fed will overplay its hand as it usually does)
- Continued rumblings about a trade war with China and the uncertainty of whether anything will be accomplished at November’s G20 meeting.
2018 Mid-term Election Results and Ramifications
On Wednesday, markets cheered the results and with the uncertainty eliminated, global markets rallied. Markets like certainty and seemed to be on guard after the surprise results of the 2016 election – such the lack of buyers in October.
Regardless of your political position, the 2018 elections results met consensus expectations. With the Democrats regaining the House and Republicans retaining the Senate, we now have what is essentially a stalemate. There will most likely be “gridlock” with few new initiatives achieved over the next two years.
The Democrats will now chair committees in the House and have warned about investigations although Nancy Pelosi will have to decide whether she wants to play the impeachment card. The following are some conclusions based upon the results:
Tax Cuts / Reform 2.0 – Further tax cuts and Tax Reform 2.0 is dead for now as Democratic opposition in the House will block key parts of President Trump’s policy agenda
Infrastructure Spending – An infrastructure / job creation measure is possible. Democrats and Republicans could agree to the idea but will likely disagree on how to pay for it.
Health Care – There will be no major health care reform or changes to the Affordable Care Act. Democrats will want to shore up Affordable Care Act and will prevent Republicans from any efforts to undo the Act. Republicans don’t want health care to collapse; the individual mandate expires at the end of 2018. We may see some health care actions on the opioid epidemic as well as some focus on controlling drug prices. The big winners are hospitals and medical delivery companies.
Immigration – The big question will be how does President Trump enforce immigration? Economically, there is a need for more legal, skilled immigrants to help the economy grow. As many as 10,000 baby boomers retiring a day is providing a current drain to the employment pool. Illegal immigration is a key issue for Republicans. The President wants to play to his base which wants a hardline, yet he also must address the issue of the country running out of skilled workers. A lack of workers may yield wage inflation as competition by companies for workers intensifies.
Trade – Global trade is the wild card. Economically, it is important to find a way to negotiate a deal with China in some capacity. A trade war hurts all parties. The global economy is already showing signs of slowing global growth and as a result international markets have struggled. For a long time, the current tariff structure has subsidized world growth at the expense of U.S. growth. President Trump is trying to reset this balance which has led to a stronger U.S. Dollar. This puts pressure on U.S. multi-nationals and international markets.
There is political pressure to negotiate a deal with China. The routine seems to be walk away, talk tough, walk away, then come back to the table as he did with Mexico, Canada, and the EU. Accordingly, the focus is now on the G20 meeting later in November and if China and the U.S. can come to some agreement. Psychologically, the President wants a deal as a trade war is negative for the economy and markets. Also, as we move towards 2020, the President will focus on re-election, and he certainly doesn’t want to lose the economy.
Expectations are that interest rates will grind higher with a split House & Senate. Our expectation is the Fed raises rates until the middle of 2019 and then pauses. The big story here is the short-term pain being experienced as interest rates rise. Of course, investors ultimately will experience a long-term gain with getting paid higher rates for holding debt.
Below is a chart from Bloomberg which shows the relationship between starting bond yields and subsequent five-year returns. As 2018 has proven for fixed income investors, it is tough to make money in fixed income while rates are rising as all securities are re-priced by the market.
Source: Bloomberg Barclays, FactSet, J.P. Morgan Asset Management. *2010s are from January 2010 to September 2013. R2 for bond yields and subsequent five-year returns is 86%. Past performance is not indicative of comparable future results. Guide to the Markets – U.S. Data are as of September 30, 2018.
The yield curve has flattened (short-term rates do not differ much from long-term rates), so staying short-term to intermediate makes sense. We continue to like floating-rate securities which as the name states, “float” higher with interest rates.
The current environment is also supportive for high yield bonds. There is a supply / demand imbalance where demand for higher yield is exceeding supply. This is reflected in the low additional premium that a high yield investor is getting over investment grade debt. With the tax reform act, there will be a change for high yield companies and how interest expenses are handled. Investors most likely will prefer high yield debt versus leverage loans.
On the equity side, earnings growth will slow as tax reform fades. This seemed to be one argument for equity market weakness in October. The question is whether earnings will back off and grow more slowly or will earnings stop growing?
With a split congress, again we have stalemate such that there will not be any new tax reform measures, but the current measures and less regulation will remain in place for at least the next two years. Our opinion is that earnings growth continues but falls from mid to high teens to high single digits. Company margins may be under pressure with higher interest rates on new debt, wage pressure to retain quality talent, tariffs, and a stronger U.S. dollar which negatively impacts U.S. multi-nationals.
Domestic vs. International Equity
We believe the trade argument will eventually dissipate and the U.S. and China will come to an agreement at some point. This is all a rebalance of growth around the world. Valuations are cheaper abroad and appear attractive.
Emerging markets are especially sensitive to the trade war and a stronger dollar. Currently, emerging markets are cheap. Resolution of the trade issue will be positive to these markets. Emerging markets have started to rally, and it will be interesting to see if these markets can break out. A review of asset classes since 2003 – 2017 show that Emerging Markets were the best performing asset class with a 12.7% annual gain for that period.
The following chart shows the U.S. versus international markets since 1997. Across the board, international markets are cheaper and pay a higher dividend, yet in 2018, investors were willing to own a more expensive market due to international uncertainties.
Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management. Forward price to earnings ratio is a bottom-up calculation based on the most recent index price, divided by consensus estimates for earnings in the next 12 months (NTM), and is provided by FactSet Market Aggregates. Returns are cumulative and based on price movement only, and do not include the reinvestment of dividends. Dividend yield is calculated as consensus estimates of dividends for the next 12 months, divided by most recent price, as provided by FactSet Market Aggregates. Past performance is not a reliable indicator of current and future results. Guide to the Markets – U.S. Data are as of September 30, 2018.
With the election behind us, we can now look ahead to what’s to come. Both a slowdown in economic growth and profit growth are expected in 2019. Markets are forward looking and adjusting to that scenario as a base case. It is unlikely that markets will experience the smooth sailing we have seen over the last few years, but equities will continue to remain more attractive than fixed income.
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