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This report, published by Key Private Bank experts, provides perspective on key economic and investment-related issues to consider in 2019.

1. How much longer can the current economic expansion continue?

The age of the U.S. economic expansion, currently the second longest since 1900, has made investors worry that a recession may be imminent. Australia’s 27 years without a recession, however, illustrates that economic cycles need not die of old age alone.

Economic cycles end when a major decline in demand cascades through the economy, impacting producers and then suppliers. For example, major disasters could trigger a recession by destroying infrastructure critical to economic activity. Typically, however, U.S. recessions have occurred when restrictive monetary policies curtail or eliminate demand by reducing access to credit.

Not that the Federal Reserve intends to cause recessions. But unfortunately, monetary policy acts with a long lag, so it takes the better part of a year for restrictions to reach their full economic impact. Thus, when the Fed raises interest rates to prevent the economy from overheating, they often overtighten before realizing they have gone too far.

In 2018, the economy strengthened significantly, in part because federal tax changes and increased government spending stimulated growth. Without additional legislation, however, growth from those sources will wane in 2019. At the same time, the tightening of monetary conditions, in the form of higher interest rates already implemented, is slowing growth. Fortunately, if normal lead times prevail, a recession still should not occur for another year or two. But we are approaching the stage where a recession will become significantly more likely if the Fed continues to reverse its ultra-accommodative policy stance first adopted to arrest the global financial crisis ten years earlier.

Ironically, slower economic growth could extend this cycle. When economic growth is fueled by adequate labor and other resources, expansions should persist without excessive inflation. If the Fed believes growth has slowed enough to allow that, they could stop raising rates. Slower growth in 2019 could, therefore, prove pivotal for Fed policy.

In short, although the current U.S. expansion is a long way from Australia’s record, it will almost certainly become our longest. Under the right conditions, this cycle may also continue for some time.

2. How much further will the Fed raise interest rates and what is the outlook for inflation?

Since December 2015, the Federal Open Market Committee (FOMC) has raised interest rates seven times. During this period, the Federal funds rate has increased from 0% to a range of 2.00%– 2.25%. Following changes to the federal tax system that were implemented in 2017, Gross Domestic Product (GDP) growth jumped to 4.2% in the second quarter of 2018 and remained above trend growth, advancing 3.5% in the third quarter of 2018. While we believe this growth is unsustainable, growth of 2.50%–3.00% is achievable in the next 12–18 months. This will likely prompt the FOMC to increase interest rates gradually in 2019.

As the Federal Reserve continues down its rate normalization path, we also expect that the yield curve will continue to flatten with short-term rates rising faster than long-term rates and will likely invert (short-term rate will be higher than long-term rates) in mid-to-late 2019. Historically, an inverted yield curve has foreshadowed a recession roughly a year or two after the inversion began. Should the historical pattern repeat, and we experience a recession 12–24 months later, we believe it would be relatively mild and short-lived before normal growth resumes, but only time will tell.

During the later stages of the business cycle, GDP growth typically slows and inflation accelerates as the utilization of resources and workers reaches capacity and demand tends to outpace supply. The current economic cycle remains atypical: While GDP growth accelerated in 2018 and the unemployment rate declined to multi-decade lows, inflation has remained subdued. Earlier this year, inflation (as measured by the Consumer Price Index) showed a sharp increase. More recently, however, that trend has lost some momentum.

The culprits, it seems, are modest wage growth, a weakening housing market, and declining commodity prices. Inflation expectations also seem well anchored.

Looking ahead, while inflationary readings of late have eased, mostly following the decline in energy prices, the Federal Reserve will likely remain active so long as employment trends remain buoyant. After all, it wasn’t that long ago when the Fed officially declared their desire to return interest rates back to their “neutral rate.”

Where exactly the neutral rate is, however, is an openended question and to arbitrarily assign a specific target to a precise rate would simply be arbitrary. It is also worth reiterating that the historical efforts taken amid the Global Financial Crisis were without precedent, implying there is no template to help guide policymakers back to the “old normal.” Still, we suspect that “neutral” is likely lower than in previous decades and thus while we acknowledge that the Fed will be active, we are also hopeful that their path is a gradual one, influenced by data as opposed to doctrine as 2019 unfolds.

3. What will 2019 hold for emerging markets and China?

To fully understand what 2019 has in store for emerging markets, we need to review the divergence that occurred in 2017 and 2018. After growing by a stellar 33 percentage points in 2017, emerging markets equities fell by over 17 percentage points by October, before rallying, to being down by about 13 percentage points at the end of November. Many of the factors that drove the strong performance in 2017 like earnings growth, driven partly by cuts in capital expenditure implemented several years ago, a weak U.S. dollar, and a yawning valuation gap relative to the U.S., either subsided or reversed by the beginning of 2018. Add rising U.S. interest rates, the fear of contagion from external debt crises in some highly visible, albeit small, economies (Argentina and Turkey), and the fallout from trade protectionism, it is easy to understand why sentiment towards emerging markets has generally soured.

We are of the opinion that 2019 will see an improvement in sentiment, as we think outflows from both emerging market equity and debt funds may have Key Perspectives—Market Outlook: 9 Key Questions for 2019 | 3 been overdone. Specifically, we think astute investors will no longer view these markets as monolithic, but rather a collection of individual countries with diverging fortunes. Those countries with current account surpluses like China, that continue to stimulate their economies, should thrive relative to those with current account deficits and limited political will. We also think that as the impact of the fiscal stimulus from tax reform in the U.S. abates, there should be a gradual slowdown in U.S. earnings growth and GDP growth, which should reverse some of the strength we have seen in the U.S. dollar. While longer-term earnings growth expectations for emerging markets have declined from 20% in December 2017 to about 15% today, they are still marginally higher than expectations for the U.S., which stands at 14%. The valuation gap that narrowed between the US and emerging markets at the end of 2017 has now marginally widened, thus favoring a relative rerating in emerging markets. We also think that a stable commodity complex, especially crude oil, may help stimulate stagnant growth in many of these economies.

Speaking of China, there are concerns that recent trade disputes could lead to significant cuts in U.S. Treasury holdings by the Chinese central bank (PBC). In our opinion, China’s accumulation of U.S. Treasuries is a strategic requirement; hence demand for Treasuries from both domestic and foreign sources should remain relatively strong. Any meaningful sale is likely to strengthen the yuan at the time when the Chinese economy is flat lining. A stronger yuan will make Chinese exports more expensive, reduce its competitiveness, and reverse the impact of some of the government’s recent fiscal and monetary policies. Over time, as the Chinese economy transitions to a consumption-driven growth model, we expect a gradual reduction in Chinese Treasury holdings. However, that transition will take many more years.

Lastly, recent elections and edicts have alleviated political volatility in Brazil and Indonesia, and power consolidation to President Xi in China stabilizes the longer-term Chinese outlook. Chinese fiscal stimulus through increased infrastructure spending, higher expected loan growth, and other protective means, could also jumpstart other nations by providing lowercost goods and services for struggling economies in emerging Asia and beyond. Overall, while risks in emerging markets are real, especially the risk of policy errors, and the path to growth will undoubtedly be bumpy, we think conditions are ripe for a turnaround in 2019.

4. Will the European Union survive?

The European Union (EU) dealt with global headwinds during 2018 and enters 2019 with unanswered questions regarding Brexit, the Italian budget, and how to navigate a generally slowing economy. Voters’ endorsement of populist movements within the EU have been rising in recent years after the surprise Brexit referendum of June 2016. Recently, Italian and Spanish elections added populist voices to national politics – voices that are less willing to compromise with EU leadership in Brussels than previous regimes. Such opposition increases the need for the EU to taper economic stimulus correctly moving forward. Bond purchase programs ended in December 2018, and most economists believe that small tightening measures could occur in the third quarter of 2019. Tightening gracefully should avoid increased opposition to the union; if the European Central Bank (ECB) tightens too quickly, more member states may become disgruntled.

In addition to European Central Bank tapering, the EU is battling a series of isolated incidents regarding its member states. Negotiations for an “easy Brexit” – the UK leaving the EU but maintaining trade and border agreements – have not gone well. No consensus has been met on trade agreements or border agreements Key Perspectives—Market Outlook: 9 Key Questions for 2019 | 4 so far. A March 29, 2019 deadline looms for departure unless all member states agree on an extension. A “soft Brexit” scenario that includes open trade and freedom of population movement would keep equity markets calm and alleviate some market volatility, while a “hard Brexit” would chain borders, limit trade, and aggravate equity markets in the short term.

In Italy, the country’s budget was rejected by the EU in November 2018. Tensions with the EU put a strain on Italian banks as widening bond spreads led to higher bank funding costs. Italy is faced with weak economic growth, high young worker unemployment, and large public debts. Cheap funding from the EU would alleviate the banking burden, but Brussels may want to take a hard line so stronger economic growers like Germany and France would not be responsible for bailing out fiscally irresponsible countries. While the Italian situation garners headlines, halving their economic growth rate would subtract a mere 15 basis points (bps) from expected EU growth in 2019. Thus, this is a political, rather than an economic, issue, and overall we are cautious about European equity and debt markets given such uncertainties.

5. How will tariffs impact U.S. profit margins?

At the end of September, tariffs on $200 billion of imports from China took effect. The tariffs were initially set at 10%, but are scheduled to increase to 25% at the beginning of 2019. And if trade relations between the U.S. and China do not improve, tariffs could become even more onerous down the road.

A tariff is a tax on imported goods which results in higher costs for companies that import those goods. If the companies affected by the tariffs are unable to offset the higher cost of imports, their profit margins will be negatively impacted.

For the fourth quarter of 2018, tariffs should not materially impact profit margins. The general view is that the higher costs associated with tariffs will be passed on to customers and/or absorbed through expense management. Keep in mind, however, that view reflects only the impact of the 10% tariff. After the tariff climbs to 25%, it will be much harder to offset the higher costs without meaningful price increases, larger expense reductions, or a significant reduction in new investments.

All told, tariffs represent a risk to corporate earnings through higher costs and lower profit margins. The S&P 500 Index is poised to deliver earnings growth of 26% for 2018, and the consensus forecast for 2019 envisages earnings growth of 12% in 2019. The expected deceleration in 2019 earnings growth is largely due to the short-term boost from federal tax law changes enacted in the 2017. Even so, double-digit earnings growth would be good news for investors.

However, earnings growth in 2019 is at risk of further slowdown if tariffs begin to take their toll on the economy. According to Goldman Sachs, a 25% tariff on all imports from China would reduce S&P 500 earnings per share by 7% in 2019, lowering earnings growth to just 5% in 2019.

6. Following a flattish and volatile 2018, how will U.S. equities fare in 2019?

A major theme for equity investors in 2018 has been multiple compression, with the Price/Earnings (P/E) ratio of the S&P 500 Index declining more than we expected due to increased trade tensions, global growth concerns, and higher real interest rates (although we did anticipate higher volatility). Heading into 2019, we see slightly above-average earnings growth—in line with consensus—which is typical at this point of the cycle where earnings continue to grow above trend, albeit at a slower pace. As always, the multiple investors are willing to pay for $1 of earnings is the most important variable for forecasting market returns. After a big decline in 2018, we believe that some multiple expansion in 2019 is likely, especially as risk abates.

The forward earnings multiple of the S&P 500 has compressed 4.4 multiple points this year, measuring from the January highs at 19.8x to the most recent lows around 15.4x. This compression was less than half the decline witnessed during the 2014–2016 market correction when the S&P 500 registered a 15% decline, but a recession did not ensue.

In 2018, profit growth has been very strong, powered by the dual forces of the recent corporate tax rate reduction and strong revenue growth driven by robust GDP. Yet, the market seems to be calibrating valuations based on both the expectation of moderating earnings growth and the presence of higher discount rates.

That said, over time there has been an inverse correlation between the change in the S&P 500 P/E in a given year and the change in P/E the following year; years of declines in P/E’s have usually been followed by increases in P/E’s (and vice versa). In fact, the market multiple has historically recouped approximately 30% of the prior year de-rating. This suggests to us that a 1.1x increase in the market multiple is within the realm of possibility in 2019.

Assuming the S&P 500 Index finishes 2018 at 2850 (16.3x forward P/E on consensus 2019 earnings per share of $175), a forward P/E of 17.4x at year-end 2019, and trend earnings growth of 6.75% for 2020, we arrive at a 2019 price target for the S&P 500 of 3250, a gain of ~14%. Additional multiple expansion and faster earnings growth would support a gain of 19%, whereas a bear case—which would entail further multiple contraction and no earnings growth—might suggest a 6–7% decline in the index.

The bottom line is that the key determinant of 2019 returns is multiple expansion. Without this, upside will be difficult to come by in an environment of decelerating earnings growth. Luckily for market participants, this is what usually happens after a year of multiple compression. But above all, investors should be prepared for a range of outcomes versus being overly confident and reliant on an exact estimate.

7. How should investors approach portfolio construction in 2019?

Amid an increasingly complex investment landscape, investors would be well served to consider several factors when constructing portfolios in the year ahead. For example, the continued normalization of short-term interest rates has made cash a viable asset class, with high-quality money market funds yielding north of 2%. The premium of holding longer duration bonds has narrowed with the continued flattening of the yield curve. Cash can also provide optionality to investors as a liquidity source during market dislocations. Within Investment Grade fixed income, shorter duration bonds may continue to provide relative value from a riskadjusted return perspective. Floating rate debt securities can also benefit from higher short-term rates if economic growth and credit conditions remain favorable.

From an equity perspective, investors may want to tilt portfolios towards higher quality companies, as higher interest rates can negatively affect more cyclical industries. Quality typically outperforms in later cycle conditions. Conversely, the value factor has outperformed in early cycle conditions, or immediately after the economy bottoms. Said another way, while value stocks may be cheap, we favor quality stocks in the year ahead.

Lastly, with tighter liquidity conditions, investors should consider diversifying strategies that can benefit from higher volatility and greater dispersion across individual securities. More specifically, with tighter liquidity conditions and the potential for volatility to revert to long-term averages, investors should consider alternatives such as hedge fund strategies. High-quality hedge funds can provide attractive riskadjusted returns and exposure to alternative return drivers such as relative value, security selection, and noncorrelated trading strategies. With high equity profit margins, elevated valuations, and tight credit spreads, returns from market beta exposure are expected to be lower compared to the last decade.

Relatedly, many investors will ask: Will active managers outperform in 2019? Higher volatility and dispersion can provide tailwinds to skilled managers. Additionally, active managers have shown the ability to profit from market dislocations. Later cycle conditions may assist in the percentage of active managers that outperform relative to the historically low levels of the past decade.

8. What should investors not be worried about?

First on this list is geopolitics. Everyone sees the bold international headlines on cable news and social media, and the concern over North Korea, the Middle East or other locales, as an individual, which can be palpable. For the markets, as the ultimate collection of individual opinion, this means it is clear geopolitics has been a factor since the beginning. Market participants can model corporate cash flows, economic growth, inflation, and any number of other things. However, it is not possible to model geopolitics. Geopolitics is completely out of our control as investors. It is a cliché, but what is going to happen is going to happen.

Given this, we believe that investors are better served by merely being aware of geopolitics, instead of getting caught up in the latest news and potentially using the information to make irrational investment decisions. As an alternative, we steadfastly suggest paying attention to the economic factors that impact corporate earnings, as over the long term, it is corporate earnings growth that drives the market.

Also high on the list of things to ignore is the general cacophony of talking heads. Keen observers in an earlier era used to confirm extremes in market sentiment using magazine covers. Essentially, when a market move had reached such a level of significance as to make the cover of a major national news magazine, this meant that an extreme in sentiment was at hand, and it was time to embrace the contrary opinion. Today, the echo chamber of television news outlets serves this useful purpose for us. When the party hats come out, sentiment is likely too bullish, and when a “Markets in Turmoil” special airs, investors are likely too bearish.

Finally, we believe investors are best served if they do not worry about valuation in the short run. Heresy, you say? Not so fast. We acknowledge that, over the long term, valuation at time of initial purchase is the singlemost important factor in determining the return an investor is likely to receive. The empirical data is clear. However, somewhat counterintuitively, it is also clear that current valuation itself has almost no ability to accurately predict returns over shorter time horizons, such as one year. Given this, we find it more important to focus on factors that drive the multiple, such as interest rates, inflation, and economic growth—we believe other market participants are better served by doing likewise.

9. What should investors worry about?

“Scaling the proverbial Wall of Worry” is an apt phrase that refers to the fact that over the long run, maintaining an equity bias has proven to be a winning strategy. Stocks, in other words, have generated superior returns relative to other major asset classes such as bonds and cash, withstanding significant exogenous shocks and highly publicized financial events. Nonetheless, several forces loom large that, if not addressed, could have significant ramifications for investors.

First, while we would acknowledge that excessive debt levels themselves may not be a tipping point, we would be remiss if we did not mention them here. Interestingly, debt service levels amid corporate borrowers, in the aggregate, have improved in recent years, and while student loan and auto debt has surged, it has coincided with declining mortgage and credit card debt outstanding. Government debt, on the other hand, which was 40% of GDP in 2008, is expected to increase from 79% in 2019 to 100% by 2030.

A debt burden of 100% of GDP wouldn’t necessarily trigger a crisis. After all, other countries are already in worse shape financially (Japan and Italy) thereby demonstrating that the 90% of GDP threshold for government debt previously suggested by two prominent economists may not be not as dire as once feared. Still, with 40% of the US debt held by non-US investors, there is no guarantee a crisis will not transpire.

Relatedly, the government deficit was already on an unsustainable path before the massive fiscal stimulus enacted early in 2018. Looking further back, in the wake of the financial crisis, the federal deficit surged to 10% of GDP, an unprecedented level, in 2010. By 2015, it was reduced to a more manageable 2.4% of GDP. But in fiscal 2019, however, the deficit is on track to widen back out to nearly 5% and would seemingly only deteriorate when the next economic downturn occurs and/or interest rates rise materially.

The fate of both forces—higher government debt and larger budget deficits—is not sealed; there are still measures policymakers can take to address these challenges, either by raising taxes or reducing benefits. Whether or not they possess the political will, however, is an open question.

More abstractly, another concern investors should acknowledge relates to an illusion of liquidity. For perspective, we think it is illustrative to spend a few minutes discussing the ubiquitous Exchange Traded Funds (ETFs).

The proliferation of ETFs and other passive investment products is well-documented, but ETFs have received a special fondness from investors due to the fact that they can be bought and sold throughout the course of a trading day, even though they are usually diversified thereby resembling mutual funds which only trade at the end of the day.

Importantly, however, and what might not be fully recognized or appreciated by investors is the fact that in the case of ETFs, it is perfectly possible that the market price at which an ETF is sold might differ considerably from the value of the underlying assets. One well-regarded investment manager explains this and its implications for investors well:

If you withdraw from a mutual fund, you’ll get the price at which the underlying stocks or bonds closed that day, the net asset value or NAV. But the price you get when you sell at ETF—like any security—will only be what a buyer is willing to pay, and I suspect that in chaos, that price could be less than the NAV…. The weakness lies in the assumption that a vehicle can provide more liquidity than is provided by its underlying assets. There’s nothing wrong with the fact that ETFs may prove illiquid. There would be a problem if the people who invested in them did so with the expectation of liquidity that isn’t there when they need it.

We maintain our view that actively-managed and passive investment strategies can coexist within a diversified portfolio. However, as captured in the quote above, the illusion of liquidity must be acknowledged and incorporated into investment strategies accordingly.

Lastly, we also believe investors should be cognizant of (and hopefully not overly worried about) their own biases that inform certain investment-related actions. We will be spending time in the year ahead discussing these biases and offering remedies to address them. But as we close, we encourage our clients to communicate with their advisors with candor and transparency. Such are the hallmarks of an engaged, long-lasting, and mutually-rewarding relationship.

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