Volatility and the Dovish Fed: Market Update January 2019

Volatility and the Dovish Fed: Market Update January 2019


By: Guy Adami, Director, Advisor Advocacy
Published January 30, 2019

In this month’s Market Update Call, Guy Adami was joined by three guest panelists to discuss the outlook for this year including the recent volatility in the markets, the apparent dovish shift of the Fed, and what investors should be prepared for in the coming months. The experienced guest panelists include Marc Nabi, Equity Investment Specialist at Capital Group; Kathleen Gaffney, CFA and a Vice President of Eaton Vance and Director of Diversified Fixed Income; and Candace Tse, Head of US Market Strategy for Strategic Advisory Solutions at Goldman Sachs Asset Management.

International Investing Vs. U.S. Based Investments

Jumping right in, Guy Adami first posed a question to Marc regarding U.S. based investments versus international investing. Is international investing ever going to do better? Marc’s answer was a definite yes – these are market cycles. From a long-term perspective, the S&P 500 over the last ten years has returned an investor 13%, while the all-country world index is up 6% and emerging markets are up 8%. When thinking about where growth will be, he predicts emerging market regions, pointing to a very large valuation gap between many companies. Examples he gave included Air Bus vs. Boeing, Addidas vs. Nike, and even technology companies like Samsung vs. Apple. We’ve experienced the U.S. as being a marketplace to be in, thanks to the strength of the dollar. Some economists believe the dollar is overvalued right now, and much of the bad news for international markets is already reflected in valuations. Many of his team are looking at non-U.S. companies in portfolios, not just the U.S. equity market.

Volatility is Here to Stay

When questioned about recent headlines spurring the market into a fury, Marc says everyone needs to get used to volatility. But don’t be discouraged; he says volatility leads to opportunity. What is he telling investors? He cites the three T’s – tightening up monetary policy, trade disputes, and too much debt. If in fact the trade dispute is temporarily resolved, yes you’ll get a reaction, but it could all change in two weeks. We just don’t know what will happen. Valuations are much higher than they’ve been in the past, and many economists are surprised at the low levels of volatility. Marc also mentioned that we are at one of the highest levels of debt to GDP in a very long time. This is something to keep a close eye on – we need to anticipate that the VIX could go up due to high levels of debt.

Candace’s take on volatility is somewhat similar; she says volatility is episodic. While volatility has appeared to rise recently in the market, we’re actually returning to more normal levels after experiencing very low levels of volatility over the last several years. In 2016 and 2017 the fear indicator averaged around 10 to 11, and the historic average is somewhere around 19 to 20. So now, investors say volatility is here to stay, but her message is that volatility is moving back to where it was historically. There will be episodes when volatility is high, but she says investors should focus on risk management within portfolios to cushion the volatility that is likely here to stay.

What we experienced in 2018 and what we experience now is much more normal. In 2017 there were only eight times in the S&P 500 where the market moved up or down 1% in the entire year. No 2%, 3% or 4% moves, yet in 2018 there were 64 moves of 1% up or down in the whole year. Investors looking at that say volatility is spiking up – but she says the message is that volatility is moving back to where it typically is. There will be episodes where it’s high and spikes, and the drivers of that volatility will be plentiful, like tariffs, geopolitics, etc. Like Marc, she advises investors to stay focused on risk management.

Speaking of volatility, what about the word recession that still gets thrown around these days? Are there any indications to lead us to believe that a crisis of the ‘07 or ’08 magnitude is imminent? Candace says “our one-year probability is fairly low, at about 10%. No recession for 2019. For 2020, low probability.” Over the next one and two year periods, it’s not in Goldman Sachs’ base case. Overall the economic data still points to a healthy economic environment in the U.S. The expansion could continue, maybe becoming the longest expansion in history; not at all concerning in terms of how close we are to the next ‘07 or ‘08 crisis.

The Weakening U.S. Dollar and the FED’s Dovish Shifting

Is the Fed shifting from its commitment to raising rates? They seemingly went from intent to move forward with rate hikes and unwinding the balance sheet to a softer stance. This could produce a potential earnings deceleration, and the dollar would weaken which would be better for international markets. Kathleen mentioned how refreshing it is to listen to Chairman Powell after years of pure academics. He was very clear when he took the chairman’s position that he isn’t going to let the market dictate the path of the Fed. The Fed is in a tough position in her opinion – the economy is actually doing really well; we know that from looking at where unemployment is. However, we now have a lot of uncertainty weighing on the market. For instance, just a headline about trade wars had the market ripping. That weighs on the market. Brexit also weighs on the market, along with concerns about slowing growth in China and also in the U.S. This puts the Fed in a difficult position, especially when the fiscal spigot seems to be wide open. Never before have you seen a point in the cycle when fundamentals are so positive, where you get a tax cut, and fiscal spend, continuing to stimulate the economy. We have a transition going from monetary policy to fiscal policy, putting the Fed in a tough position.

The dovish comments, she speculates, are there to help weaken the dollar. The Fed doesn’t have a lot of latitudes. If the uncertainty in the market is going to impact growth, we don’t want to be tightening. However, we also need to get things back to normal before the next recession. So the Fed is on a mission to get back to normal as soon as they can, within reason. Talking the dollar down, or weakening the dollar, is a great strategy that could give us a little bit of an economic tailwind. However, it is a tough place to be as the market is changing.

Candace predicts raising rate hikes twice in 2019, after such a strong year, and that the dollar will weaken throughout the year after exceptional growth in 2018.

Moving to Credit and Best Sources of Return

When asked if there was anyplace along the credit curve or within credit instruments where we should be concerned, Kathleen responded that in a declining rate environment, bonds can be a good thing as they are a hedge to equity volatility. With rates so low, the credit markets are now fairly stretched. Not one area of the credit market is cheap. In the last several weeks, there has been a backup in spreads, and you could say they’re a lot cheaper than they were a year ago, but that’s not saying much when interest rates are still at a low level. The signal she and her team are seeing is that higher quality corporate bonds have not demonstrated the same kind of rebound seen in high yield. The challenge is that interest rates have moved up just enough that there isn’t enough coupon for investment grade to keep posting a positive return if we’re looking at rising interest rates. Value is starting to return, but what her team is doing is holding onto cash to be patient as values begin to move back into the market. She agrees volatility is here to stay, so it’s a good time to be patient and pick your spot.

As far as the best sources of return? Even though it’s early in 2019, our panelists keeping an eye on risk. If interest rates are moving higher, you don’t want to take a lot of risks. If credit is overvalued, you don’t want to be jumping too fast into credit. The alternatives, where there is value is in cash, and looking away from the U.S. currency, whether it’s developed markets or emerging markets – those will be areas of the market that will allow fixed-income investors to be able to realize a positive return. A multi-sector approach allows for the ability to be flexible, going across sectors. There isn’t really any one sector, maybe other than cash but you don’t want to be 100% in cash, that is going to be able to generate a strong return.

Final Words of Wisdom

From each panelist, Guy asked for their imparting words to investors. This is their advice for moving forward in 2019:

Marc Nabi: He mentioned three things: Be prepared for more volatility. Stay the course and don’t let market declines make you flinch! He ends with this recommendation: diversification. The U.S. is not the only equity market out there. There are industries out there that are attractive outside of the United States.

Kathleen Gaffney: While bonds are facing headwind of rising rates, that doesn’t mean get out of bonds. Think of different ways for bonds to generate better return such as through country currency and be willing to embrace volatility and use your cash to buy into other markets that are becoming more attractive as rates move higher.

Candace Tse: There are many potential concerns for 2019 including the Fed, trade tensions, etc. She says even withstanding all those pressure points, her team is still pro-equity vs. fixed income, pro-credit vs. rate and they really like emerging markets. At this point, recession is not their base case scenario, and risk management is key in this market of episodic volatility.