Each January since 2016, I have forecasted three surprises for the market. These Uncommon Sense articles continue to be the most widely read every year. Odd, because most market watchers claim that investors don’t like surprises. Despite my own skepticism about predictions, as a chief investment strategist, I’m forced to participate in this annual exercise.
While my three surprises have been dead-on seven of nine times over the last three years, it’s not my track record that’s most important. Rather, my forecasting gives me the opportunity to remind investors that while they can never control investment outcomes, they can always control the investment process. The formula I use to identify potential surprises each year has remained consistent and disciplined. I limit the number of surprises to three. Trying to predict too much is a recipe for failure. The time horizon is short—just one year. Lastly, I look for unloved assets with compelling valuations where bad news is already priced in and investor opinion on the asset is decidedly one-way. Assets that exhibit these characteristics are ripe for surprises.
Here are my three surprises for 2019:
1. US fiscal policy repeat
My first surprise for 2019 is that Republicans and Democrats will reconcile long enough to pass fiscal policy legislation this year. Of course, that might be tough to imagine given the current state of affairs in Washington where a government shutdown that began on December 22 is now the longest in US history and doesn’t appear likely to end anytime soon. In the face of this ugly political divisiveness, investors are increasingly concerned that the Trump administration, Republicans and Democrats will fail to work together to tackle the country’s most difficult challenges.
However, I see the Trump administration and the 116th Congress working together before year’s end. Disgracefully, it is going to take a slowing US economy and marginally tighter monetary policy just prior to a national election year to unite these scoundrels. They will partner on fiscal policy simply to save their sorry incumbent backsides in 2020.
In fact, it is quite common for the government to grease the skids before a national election. Look no further than the end of 2015. That December, Congress agreed to provide $305 billion to repair and expand highways, bridges and transit over the next five years.1 In addition, after years of sequestration that capped government spending, a deal between the White House and Congress was reached in 2015 to set spending levels through 2017 to ease budget and spending negotiations ahead of elections in November 2016. That deal included $50 billion in spending increases divided equally between defense and domestic programs for 2016 and an additional $30 billion in spending for 2017.2
Republicans and Democrats will most likely compromise on increased infrastructure spending. Beyond the obvious winners like materials and industrials, energy is likely to benefit as both parties want to modernize the grid. Here, Democrats will likely focus on clean energy generation and energy storage solutions while Republicans will tend to favor reducing the pipeline backup and increasing power generation. Longer term, greater infrastructure spending also could positively impact real estate by spurring new development.
2. Financials outperform the broader market
My second surprise is that the financial sector will outperform the broader market. Higher interest rates were supposed to help boost financial companies’ profitability last year. The US Federal Reserve held up its end of the bargain by raising the target fed funds rate four times in 2018 and nine times since the end of 2015. Unfortunately, the flattening yield curve spoiled financials’ fun in 2018. Most financial companies earn profits by borrowing from demand deposits like savings and checking accounts that pay depositors a low interest rate while lending longer term at higher rates through mortgages and business and consumer loans. The wider the spread between the interest rate financial companies pay depositors versus the interest rate they collect on the loans, the greater the profit.
Unfortunately, short-term interest rates increased more than long-term interest rates last year, flattening the yield curve and curbing financials’ profitability. In addition, attractive relative valuations combined with a less burdensome regulatory environment at the start of last year also led investors to aggressively overweight the financial sector. When things didn’t pan out as they planned, investors lost patience with their financial sector positions, withdrawing nearly $9 billion from financial sector exchange traded funds (ETFs)—the greatest outflow of the 11 economic sectors.3 Financial sector performance wasn’t much better, declining 13% and trailing the S&P® 500® Index by 8.6%.
Needless to say, the financial sector is unloved as we enter 2019. Trading at an eye-popping 55% discount relative to the broader market based on price-to-earnings multiples, it potentially offers compelling value to investors willing to accept the risk of investing in the sector. According to FactSet, fourth quarter earnings per share (EPS) growth for financials will be more than 10%, roughly in line with the market EPS growth rate. Year-over-year net profit margins for financials are likely to eclipse 16%, more than 5% greater than the year-over-year net profit margin of the market and the third highest of the 11 economic sectors.4
As of early January, fourth quarter earnings season is off to a tremendous start for financials in spite of the flat yield curve. Expectations for a flatter yield curve in 2019 will continue to weigh heavily on investor sentiment for financials. However, the Fed has signaled a slowing of interest rate increases in 2019. In fact, 2-year Treasury rates have already fallen from a high of 2.97% in November to 2.54% more recently. The yield curve may not flatten as much as investors are expecting. Maybe it will even steepen some this year and unexpectedly boost financials’ profitability.
Source: Bloomberg Finance L.P., as of January 15, 2019.
3. Junk Bonds Fail to Rebound for the First Time Ever
My third surprise for 2019 is that high yield bonds continue to struggle and returns are not likely to be anywhere close to typical results after previous down years. According to Bloomberg, high yield bonds limped into 2019 after suffering from a December selloff that was the worst month for the asset class since 2011.5 Most high yield experts chalked up the volatility to a liquidity driven event rather than a negative assessment of the asset class’ fundamentals. An index of high yield bonds declined about 2.6% in 2018. Despite the losses, strategists have been ratcheting up their forecasts for high yield bonds in 2019. Perhaps they are emboldened because high yield bonds have only suffered an annual loss seven times in the last 35 years and they have never had negative returns in consecutive years. In fact, on average high yield bonds have surged 29% in the calendar year following a negative performance year.
A number of additional factors support the positive outlook for high yield bonds. The US economy is likely to grow 2.5% this year, corporate profits are rising albeit at a slower pace, the Fed is taking a pause from interest rate hikes, inflation expectations are modest, high yield supply is shrinking and default rates remain low relative to their long-term history. What’s not to like?
However, monetary policy conditions have tightened and the Fed may raise rates once or twice this year. Both US economic growth and earnings are decelerating. High yield spreads relative to Treasuries widened last year but remain well below long-term historical averages. This means the compensation investors receive for taking credit risk is still way below historical norms. And although supply is shrinking, high yield bond issuance has exploded in the post-global financial crisis environment of low rates. As a result, even marginally tighter monetary policy, slowing growth and earnings may have outsized negative impacts on default rates and spreads.
I’ve had some fun forecasting these surprises for 2019. But, again, the takeaway for investors is to focus on a consistent, disciplined investment process and live with the outcomes. This is an important reminder in the aftermath of a difficult 2018. So, happy hunting everyone! And for more detail, read my full Uncommon Sense.
1Bart Jansen, “Congress approves $305B highway bill,” USA Today, December 3, 2015.
2Kelsey Snell, “Budget deficit set to rise thanks to year-end tax deal,” The Washington Post, January 19, 2016.
3Bloomberg Finance, L.P., January 16, 2019.
4Earnings Insight, FactSet, January 11, 2019.
5Kelsey Butler, “Junk Bonds Forecasts Are Quickly Going from Good to Great,” Bloomberg, January 15, 2019.
S&P 500 Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
Earnings Per Share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
This document may contain certain statements deemed to be forward-looking statements. All statements, other than historical facts, contained within this document that address activities, events or developments that SSGA expects, believes or anticipates will or may occur in the future are forward-looking statements. These statements are based on certain assumptions and analyses made by SSGA in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein. Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond SSGA’s control. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.