To recession or not to recession? That is the question
The fourth quarter of 2018 was nothing short of a disaster for the equity market. After peaking at a new all-time high of 2,930 on Sept. 20, the S&P 500 proceeded to drop nearly 20% in just 13 weeks, culminating in the worst December for equities since 1931 and the first down year for stocks since the Great Recession.
Both the duration and depth of the sell-off were surprising given the economy's underlying strength. In 2018, GDP growth likely approached 3%, the fastest pace in 13 years, S&P earnings expanded at over 20%, the fastest growth rate in eight years, and the economy added over 2.6 million jobs, the most since 2015, topped by December's particularly robust gain of 312,000 nonfarm jobs. All this occurred with inflation remaining remarkably well-behaved, with the core PCE just under the Fed’s 2% target.
It is worth remembering the market tends to be forward looking, which suggests the downturn we’ve seen since September indicates investors are pricing in a recession this year. And to be clear, there are potential clouds on the horizon. The trade war with China has created uncertainty, with the threat of a substantial increase in tariffs on $200 billion worth of goods in the event that the two sides fail to reach a deal by March 1. This uncertainty already has caused corporate confidence to retreat from cycle highs and capital investment to decelerate. China, too, is feeling the pinch as its economy has slowed, pushing overall global economic growth downward. The Fed also has been a source of volatility, with Chair Powell delivering mixed messages, first suggesting interest rates were well below neutral, then suggesting rates essentially were at neutral, then after December’s rate increase, suggesting two more are in store this year in addition to an accelerated balance sheet run-off. Last week's weaker-than-expected ISM manufacturing report and rare profit warning from Apple further fanned the market’s recession fears.
So where does this leave us as we head into 2019? While we acknowledge economic risks have risen and growth is likely to slow, we don’t see a recession at this point as virtually none of the classic indicators of recession have yet to flash red. The yield curve has flattened but has yet to invert, inflation trends remain benign, unemployment claims remain near cycle lows, credit spreads have widened a bit but remain well below recessionary levels, the ISM manufacturing index continues to be solidly in a growth regime and earnings growth remains positive. We do foresee softening, with economic growth slowing to 2.5% vs. nearly 3% in 2018 and earnings growth reaching 5-10% vs. 20-25% a year ago. In that context, we view the current turmoil as a non-recessionary sell-off, similar to what was experienced in 1987, 1998, 2011 and 2016, when the S&P on average fell 20% over five months with a sharp spike in volatility. Equities rebounded sharply once the market had weathered the storm, with an average forward 12-month return of 32.5%.
Our belief this is a non-recessionary pullback is the primary reason we expect markets to move higher over the course of 2019. That said, investors are not in a trusting mood. A sustained move higher, toward our long-held target of 3,100, likely will require more certainty around trade via a formal deal between the U.S. and China, a definitive Fed pause, a tenable Brexit solution and a stabilization of economic and earnings growth, even if at slower levels. While we expect more clarity in the current quarter, with Q4 earnings season kicking off Jan. 15, the U.S.-China trade deadline on March 1 and the next big Fed meeting on March 20, the longer it takes for confidence to be restored, the more we run the risk of the market pullback creating a crisis of confidence that bleeds into the economy, creating a negative feedback loop that heightens the risk of a recession both here and abroad. So while we are hopeful that the Christmas Eve low of 2,350 ultimately will represent the bottom, we fully expect volatility to continue over the next few months and would not be shocked to see a retest of that level before eventually moving higher.