Tuesday, December 18, 2018

Outlook 2019: Seeing the Picture When the View is Less Than Clear

The outlook is complex with a myriad of issues that can influence the economic setting and financial market behavior. Much depends on the evolution of interest rates, trade, and the global economy.


Overview

• While conditions for a recession do not present an immediate concern, growth will likely drift closer to trend as the positive fiscal impulse begins to fade.
• The domestic landscape should remain fertile for corporate profit growth to endure, albeit at a decelerating level from last year’s heady pace.
• Equity markets should overcome intra-period volatility to advance. An overly cautious stance toward risk assets is unwarranted, but the year may require a flexible investment strategy.
• The Federal Reserve (Fed) will very likely pause and may halt its rate hikes for this cycle, bringing to an end the run of higher short-term interest rates, which began in 2015.
• Absent an inflation shock, it appears intermediate- to longer-term yields have peaked and the bond market is going to price an economic slowdown.
• The credit cycle appears to be turning, which would further pressure credit spreads and feed back into demand for high-quality assets.
• Bouts of volatility in the fixed income market may impair those areas exposed to greater credit risk the most.
• Investors who reposition and reduce their riskier bond investments (e.g. high yield corporates, emerging market debt) will fare better than those who continue reaching for yield at any cost.
• The municipal new issue pace should pick up in 2019, although Congress is unlikely to enact any significant infrastructure legislation in support of state and local governments.
• Municipal market credit conditions are stable, but growing liabilities, particularly those associated with underfunded pension plans, remain a largely unaddressed credit headwind.

Economy & Equity Markets Outlook

Mark Luschini, CMT, Chief Investment Strategist
Successful macroeconomic analysis usually comes down to the application of the Pareto Principle, also known as the 80:20 rule. In other words, the vast majority of what matters, the ‘80’, is explained by a smaller number of drivers, the ‘20’. In this, we find our search for the ‘20’ leads us to a few that matter most to open the New Year. The evolution of them will dictate their impact and possess the potential to alter the path our forecast rests on. They include: 1) will the U.S. economy absorb higher rates and slipping global conditions; 2) can China arrest slowing growth while deleveraging and combating tariff tensions; and 3) oil’s price evolution. Continue reading.

Fixed Income Market Outlook

Guy LeBas, CFA, Chief Fixed Income Strategist
In 2015—eons ago—we first discussed “peak” interest rates for the current cycle, mainly in terms of the peak federal funds rate. The underlying thesis was that demographics and slow productivity gains “cap” how high rates can go. It looks like we have hit that cap. The conclusion then and now is that rates were likely to peak in the current cycle in December 2018, as evidenced by trading and economic fundamentals. While that peak date shifted in our thinking over time, it looks like we are finally there. Continue reading.

Credit Markets

Jody K. Lurie, CFA, Director, Corporate Credit Analyst
Volatility is the New Normal
Themes in Corporates: 2018 contrasted with 2017 meaningfully as volatility re-entered the market environment. Various headlines, including the Fed’s rate hikes and balance sheet runoff, tariffs and trade war, emerging markets challenges, Brexit progress (or lack thereof), and rising softness in housing and autos, cascaded into the taxable fixed income market by way of negative total returns and swings in credit spreads. Playing in the background has been the narrative of a yield curve inversion, coupled with movements in corporate bond credit spreads, as measures of economic and market health near term. Continue reading.

Municipal Markets

Alan Shankel, Managing Director, Municipal Strategy
Tax Reform and Muni Market Dynamics
The 2017 Tax Cut and Jobs Act dramatically changed municipal bond market dynamics by slowing issuance (no more tax-free advance refundings) and shifting demand patterns. With a lower corporate tax rate (21% from 35%), banks have less need for tax-free income. Through the first three quarters of 2018, after decades of annual increases, bank holdings of municipal bonds dropped by $40 billion or 7%. Continue reading.