Is 2019 the Year of Upside Surprises?

The sharp selloff in the stock market in the fourth quarter of 2018 was fueled by technical factors and algorithmic trading, not necessarily a deterioration of economic and corporate fundamentals. Despite a 14% decline in the S&P 500, 2019 earnings growth estimates dropped only 2.5% during the same period.
Investor sentiment has grown increasingly negative, which sets the stage for upward surprises in 2019 valuations and earnings. 11.5% earnings growth is a realistic target for the year given the continued strength in consumer spending, wage growth, cost-cutting and share buybacks.

We also expect to see a broad-based global equity rebound in 2019. A confluence of factors should combine to drive stock prices higher including progress in trade talks with China, upside earnings surprises, strong GDP data and a more communicative and transparent Federal Reserve. We have already started to see some early signs of a rebound: the S&P 500 rallied 6.5% in the first three weeks of the year through Jan. 18.

Inflation is being held in check, fundamentals remain intact and economic growth continues—albeit at a slightly slower rate. We continue to emphasize portfolio diversification. Given the volatility we saw in 2018, it may be a prudent time for investors to rebalance their portfolios as allocations most likely drifted from intended weights. If there is cash on the sidelines, consider putting it to work in asset classes and sectors with attractive valuations.

In our model portfolios, we maintain a slight overweight to large-cap value versus growth heading into 2019. We hold a slightly positive view of international equities as we believe attractive valuations and earnings growth should continue to propel risk assets abroad. International small caps may be a good diversifier to large-cap exposure given its idiosyncratic aspects.

Long/short equity strategies should benefit from increasing dispersion in equity markets and have the ability to dampen volatility during market downturns through alpha short positions and active portfolio management. Catalyst-focused, event-driven strategies are currently attractive and poised to take advantage of the continued high volume of corporate deal flow, a favorable tax environment and relatively favorable corporate borrowing rates. These process-driven—rather than market-driven—strategies allow investors to access corporate equity and credit markets with less valuation risk. Additionally, the expected returns of these strategies should improve as the Fed continues to raise interest rates.

In early 2018, we made a conscious shift toward event-driven strategies due to their low correlation to other asset classes. We have since seen strong performance and asset flows in those areas. Both long/short equity and event-driven strategies held up well in the face of heightened volatility in the fourth quarter of 2018.

We have strong conviction in managers that are active on the short side, employ options to maintain their flexibility and generate alpha on the short side of their books. Managers that use macro hedges to limit losses during a significant pullback are also attractive due to their ability to withstand steep market losses. Elsewhere, we favor private investments that have lockup periods of three to seven years and have the ability to call capital in less than 10 years. Another area where we see promise is in opportunity zone funds, which can create significant tax savings for investors who reinvest their capital gains in them.

Barring a significant rise in inflation, we expect the Fed to pause interest-rate hikes in the first half of 2019 and potentially raise rates again late in the year. Look for the Fed to continue to unwind its QE program while interest rates drift higher. We expect the 10-year Treasury yield to end the year between 2.9% and 3.25%. We see the Treasury yield curve staying nearly flat for the entire year but not inverted for a meaningful period of time.

Fixed-income investors should stay focused on earning income—not overreaching for yield—and taking advantage of attractive market opportunities. The corporate spread widening witnessed during the fourth quarter of 2018 has created an entry point for long-term investors. We anticipate that corporate bond spreads will initially tighten and then stabilize, remaining flat for most of the year. In credit, we’re generally underweighting commodities and cyclicals while overweighting consumer and defensive sectors. We continue to underweight the Treasury, agency and mortgage sectors as we think relative value is lacking.

Overall credit quality of high-yield companies should remain sound with defaults remaining in the 2% range—well below the 4% long-term average—during 2019. We will continue to position our high-yield investments defensively, focused on B and BB credits. Tax reform changes (limited deductibility of interest) should somewhat discourage leveraging transactions, limiting an already scant new-issue calendar. Similar to 2018, we’re focused on avoiding credit issues and clipping coupons during 2019.

Credit conditions of municipal debt should continue to show strength in 2019, especially in areas that did not meaningfully boost leverage during this economic expansion. The challenges for municipalities over the next 12 months will be fairly similar to previous years: increasing expenditures, budgetary imbalances, a lack of funding to fix deteriorating infrastructure and, in some areas, political gridlock.

We aim to progressively improve overall credit quality in the portfolios in an effort to protect investors from an economic slowdown. Since 2007, pension risk and the underfunding of public workers’ pensions have been key considerations in any potential investment. We continue to avoid states and cities with low funding levels, as the risk/reward ratio is not favorable at this time, particularly if an economic slowdown is in the offing.

During the past 12 to 18 months, our strategy has been to keep portfolio durations fairly conservative as we progress through a period of Fed tightening. In 2019, we expect to gradually extend duration in the portfolio in anticipation of slower growth in 2020.