Another Fund Manager Forecast Urges Tempered Optimism

Charles Schwab Investment Management this week published its annual equity and bond market outlook, which reminds investors that volatility is a normal part of investing—and that making emotion-driven trades is rarely a good strategy.  

“I have seen commentators saying we are already in a bear market, but I like to point out that it’s really hard to establish when a bull market becomes a bear market until you have the benefit of hindsight,” said Omar Aguilar, chief investment officer for equities, during a conference call introducing the new market projections. “What we can say with more confidence is that we are starting to go through a change in the business cycle. We’ve been in an incredibly long growth period, so I do believe that we have entered the phase where the U.S. economy will be decelerating through 2019.”

But this is natural and by no means indicates a likely recession, Aguilar said. He pointed out that the U.S. economy recently saw a very strong peak of 4%-plus GDP growth for the second quarter of 2018.

“As we come down from that peak and the interest rate environment normalizes, next year we can expect 2% to 2.5% growth in GDP,” Aguilar said. “Take note, this is not a recession. It is simply a slowdown in growth. This point seems to be missed by a lot of people.”

According to Aguilar, one driver of lower growth is that interest rates are moving higher, which means lower liquidity for businesses, which can increase volatility in equities.

“The headline is that we are going into a natural deceleration period with respect to global economic growth,” Aguilar said. “Zooming in a little bit, this includes deceleration of the earnings cycle. What this does is put an emphasis on quality, versus the momentum market that we saw during the early parts of 2018. This is a very typical shift that we have seen before, and it brings higher volatility and higher interest rates.”

Aguilar said this forecast does not suggest investors should wholesale rotate their portfolios away from risky assets, “but investors should be more thoughtful about the growth assets they hold.”

Globally, Aguilar expects there will be challenges but also opportunity as well.

“The economy in Europe is more stable than what it was just a few years ago, even with concern about Brexit, so there may be more upside than even what we see in the U.S.,” Aguilar said. “The same applies to emerging markets, because we see attractive valuations and an expectation that the dollar may weaken in 2019. This would benefit emerging market performance.”

Aguilar concluded that there are strong reasons for optimism and that investors who are willing to stomach volatility in the next year could benefit.

“If you look at the economic data, it is still very strong,” he said. “Unemployment is as low as it can be, and investor sentiment remains pretty high. We’ve had record earnings in the last quarters, so it is a mystery to some extent why we are see questing of the bull market. Really the behavior of investors has changed in the second half of 2018—they are more afraid of risk—and this is leading the volatility, I think. It’s the fact that risk aversion has gone through the roof, which drives a flight to quality.”

As evidence of this, Aguilar pointed out that the stock markets, until relatively recently, did not react much to the tweets of the U.S. President.  

“As investors have grown jittery, we can now see clear spikes volatility coming on the back of the President’s threats and statements with respect to global trade and other issues,” Aguilar said. “Our suggestion for investors is to stick to your plan and remember your long-term objectives.”

Concerning the bond markets, Brett Wander, chief investment officer for fixed-income, said he also feels optimistic about 2019.

“We are getting a lot of client questions about uncertainty having to do with Brexit and the trade dispute with China,” Wander said. “Interestingly, these topics are dominating news headlines, but by and large, long-term interest rates have not really responded.”

Turning specifically to the question of rate hikes, Wander said the Fed is widely expected to raise rates again in 2018, “but this is actually not a done deal.”

“We’re less than a week away from the December meeting, and I would say this is the most uncertain call we’ve seen ahead of a meeting in some time, probably three years,” Wander said. “With the equity market volatility, it’s not as foregone a conclusion that they will raise rates again this year. The market is pricing in about a 75% chance of another rate hike in 2018.”

Still, for 2019, Wander expects the Fed is likely to raise rates, at least once or perhaps twice. Unless markets bounce back in a big way before year end, Wander said the Fed may back off from its recent pace of doing one rate hike per quarter.

“Regarding the yield curve, the conventional wisdom is that a flattening or inverted yield curve is a precursor to a recession,” Wander said. “But I really think we need to be hesitant about this story line. It’s not like the yield curve is a light switch for turning on a recession. If we see a slight inversion of the yield curve, it doesn’t mean much at all, especially given the confluence of technical factors that are influencing interest rates right now. It’s only when we get to a 50 basis point or a 100 basis point inversion that I think this yield curve-based recession argument makes sense. We are still just not in a normal interest rate environments.”