With the S&P 500 experiencing its worst December since 1931, followed by the best opening eight weeks of a year since 1991, all helped along by a sharp volte face from the Federal Reserve, for investors, a sober analysis of what drove the market excesses in both directions can help plot a course through what looks set to be a volatile year. 
December’s headlines told a tale of earnings downgrades, inexorably tightening of monetary policy and simmering trade-related angst – and were quite happy to ignore the positive news from labour markets and the consumer.
By contrast, headlines so far this year have sliced through the usual late-winter gloom with optimism over trade and applause for every earnings beat – even if from a low base – while studiously ignoring the ongoing earnings downgrade cycle, weakness in European data and the limited participation in the rally. As is so often the case, both were overreactions.
The US economy is certainly late stage of the economic cycle but with a limited risk of recession. It is important, however, not to confuse the Fed’s recent action of “easing off the brakes” for “pressing on the accelerator.” In 2016, with a US economy still in mid-cycle, significant stimulus hitting the Chinese economy, and real interest rates well below zero across the world, the Fed’s patience was a big boost.
Roll forward to today and, while the Fed’s pause has given welcome relief to a nervous market, it is at least in part responding to slower economic growth. To be clear, trend-like growth is no bad thing for the US, particularly when the household sector is in generally good health. But a decline in the pace of growth simply doesn’t augur well for a reacceleration of corporate earnings growth from an already elevated level – especially when the world economy ex-US looks decidedly less robust.
In China, as in the US, hopes for a resolution to the trade dispute gave a boost to sentiment. Clearly, avoiding further escalation of the level or scope of tariffs is broadly positive, but doesn’t walk back the tariffs already imposed. Nor is it likely that any near-term agreement meaningfully addresses the deeper impasses over intellectual property rights, cybersecurity, and how any deal going forward will be monitored.
A further complication is that importers appear to have been stockpiling essential Chinese goods to protect their supply chain. Despite tariff threats and persistently weak global capex data, Chinese export data held up well in 2018, which suggests that even if a deal is reached, excess inventories will need to be run down – in turn, creating a headwind for Chinese data in the first half of 2019. This may elicit further stimulus from Beijing, but before getting too carried away, we should note that stimulus so far has yet to fully unwind the tightening of the last few years.
Moreover, as Chinese policymakers are anxious to avoid stoking asset bubbles, stimulus measures are likely to focus on specific sectors of the economy rather than simply aim at boosting aggregate activity.
Although not an explicit target, Europe found itself caught in the middle of the trade dispute. The integrated nature of global supply chains, together with Europe’s position as, simultaneously, a supplier of capital equipment and a consumer of Chinese intermediate goods, put the region in a precarious position. Industrial activity data, factory orders, business sentiment and reported GDP growth all took a significant hit in the second half of 2018 as European growth slowed abruptly.
Europe is however far more stable than it was seven years ago, but the sheer size of its banking sector, the weight of financials in its equity index, and the dominant role of bank lending in company financing all detract from the region’s resilience. As global growth slows to trend, Europe’s bank balance sheets are likely to weather weaker growth, but bank earnings may not – especially with the European Central Bank’s negative rate policy now likely to remain in place through 2019.
Stitching this all together, markets are in limbo. Growth is positive if unexciting and the rate of change in growth is still pointing downwards. This creates a headwind for earnings that will likely persist through the first half of 2019.
Investors were probably too cautious in December, but equally, investors may be a bit too sanguine now – 2019 is not 2016 redux and the Fed’s pause was not a reflection of economic strength. On the bright side, however, if slower growth means lower earnings expectations, then US markets have probably factored in much of that slowdown. Trend-like US economic growth of 1.75 per cent would support low single-digit earnings growth. The issue today is that markets have moved rapidly to reprice this changed environment, and with the S&P 500 close to 2,800 at the time of writing, further meaningful upside may rely more on hope than reality, at least in the near term.
Elsewhere, the outlook may be even cloudier. Easier financial conditions may support asset prices in China and other emerging markets, particularly if the US dollar weakens in 2019. However, as companies unwind inventories built up in anticipation of trade friction, it may keep macro data and asset prices under pressure for a while yet. But in Europe data has been persistently weak, yet forecasts of 2019 corporate earnings have barely budged. As 2019 European earnings expectations are scaled back to reflect a slowing global growth outlook and earnings trends in other regions, including the US, it will create a meaningful headwind for European stocks.
2019 is not a year for taking large outright equity positions. Instead, as earnings trends reset, relative value trades across regions could provide good sources of return. The US continues to stand out with some attractive opportunities and the outlook for some carry assets following the Fed’s pause looks rosier. But investors should bear in mind that in late cycle, with the Fed on pause, there is a good argument for a sizeable allocation to duration within a balanced portfolio.
John Bilton is head of global multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.