• U.S. equities have declined nearly 10% so far this quarter as measured by the S&P 500

  • Trade sanctions and tighter monetary policy amid signs of a softening global economy

  • Recommend reducing overall equity exposure to neutral due to elevated risks

  • U.S. GDP growth forecast unchanged at 3% for 2018 and 2% for 2019

  • Maintain slight overweight to U.S. Large Cap due to relatively attractive risk/reward tradeoff

After a rough October, U.S. equity markets have continued to struggle over the past two weeks. This week’s two-day selloff of over 3% wipes out year-to-date gains for the Dow Jones Industrial Average and S&P 500, while the tech heavy Nasdaq is also now flat for 2018. Amid the decline, investors sought safety in U.S. Treasuries, causing the yield on the 10-year note to fall to 3.06%, down from its recent seven-year high of 3.24%. Meanwhile, volatility has been on the rise; markets have closed +/-1% on 50 days thus far in 2018, with 14 of those days since the start of the fourth quarter. This is a stark contrast to the third quarter which didn’t experience a single day of +/-1%. After only eight such days in 2017, it is understandable why investors might be on edge.

What’s Ailing Markets

Markets are wrestling with a host of issues around growth, including whether the global economy is slowing, corporate earnings have peaked, the Fed is too restrictive, or U.S.-China trade tensions could worsen. Although these are the same issues investors have been grappling with at different points this year, the market is struggling to find its footing as these issues are now coming to a head simultaneously. While the selloff has been broad-based, the growth-oriented technology stocks have been punished to the greatest degree, as concern about demand, potential regulation and the impact of the U.S.-China trade dispute weigh on the sector.

A Positive but More Cautious Outlook

It is important to remember that economic and earnings growth fundamentals remain positive. We expect the U.S. economy to deliver 3% real GDP growth in 2018, aided by last year’s tax stimulus and a healthy consumer. But we do expect that pace of global growth to slow in 2019, with the U.S. economy transitioning to 2% growth as fiscal stimulus begins to fade and financial liquidity erodes. Expectations for corporate earnings growth have also come down, but we still expect S&P 500 companies to deliver a year-over-year earnings growth rate of 5-10%. While our base-case outlook for earnings for 2019 has not been revised lower, the potential for a downside surprise has increased.

We continue to monitor Fed actions and trade/tariff developments as progress on any of these fronts could be the catalyst that eventually moves markets higher. But the opposite is also true, as these same issues pose significant risks to our outlook if they are not resolved positively. Of these, trade is the biggest risk to our outlook, largely because there is no historic precedent to forecast how markets will react.

Investment Implications

We believe that a neutral weighting in equities is most consistent with the full spectrum of possibilities related to trade, monetary policy, and the global economic outlook at this stage of the investment cycle. As such, we are recommending the following changes be made to client portfolios: 

•Over the last few months, we have taken steps to reduce equity exposure in two asset classes, small and mid cap domestic equities.

•In order to balance our greater perception of downside risk to portfolio positioning, we wish to continue with that process and are recommending an additional reduction in equities to bring client portfolios to a neutral equity position. We are also recommending a neutral exposure to high yield, which can be more volatile in times of uncertainty.

•Proceeds from these reductions will be reallocated to core fixed income.

•Within equities, we continue to favor U.S. markets to the rest of the world, as we continue to underweight emerging markets.

Going Forward

This stage of a market cycle can last some time, but it also requires careful monitoring in order to balance risk and reward. Volatility may be a consistent theme in the weeks and months ahead as the market looks for some clarity on trade and whether the Fed will take a pause. While a short-term bounce and year-end rally certainly are possible if we hear less hawkish commentary from Fed officials and positive trade developments at next week’s G20 meeting, the overall heightened level of risk may continue to suppress P/E multiples into 2019.

We continue to monitor the aforementioned issues plaguing the markets as well as other important variables that are critical to our outlook. This neutral posture in equities provides portfolios more flexibility to take advantage of market opportunities should they present themselves over the course of the next year.

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