Volatility was the name of the game in 2018 as the global equity markets set record highs only to see those yearly gains erased. The sell off at the end of the year sent the equity indices into correction territory. Several forces conspired to create this environment, including macro events like the global trade slowdown and tightening monetary policy, as well as the staggering of the FAANG (Facebook, Apple, Amazon, Netflix and Google-parent Alphabet) stocks, which have been a major equities catalyst over the past couple of years.
Looking ahead, we believe the markets are likely to remain choppy for some time, but are resolute the 2019 landscape will present more selective opportunities, with greater emphasis on the fundamentals and quality of asset classes, sectors and securities.
- The sector saw a material pullback in equity prices in 2018, with many companies revising earnings lower. We expect more such revisions in the short term, but believe these stocks are forming a bottom.
- Semiconductor stocks were the first to signal a slowdown in the sector, but we think that move is mostly done and believe this group should perform better in 2019. We think demand is likely to be solid, although clarity around the ongoing trade dispute will be a key factor.
- We have a bias toward higher-quality companies that demonstrate resilient business models, strong capital allocation frameworks, meaningful efforts to protect earnings per share, and efforts to return free cash flow to shareholders.
- We think internet-related companies will offer investment opportunities in 2019. In general, internet companies that have cash-rich balance sheets and high free cash flow margins, and that are benefitting from the increased adoption of new services, should be able to weather any economic downturn. That said, the relatively short operating histories of many fast-growing internet companies means the inherent cyclical nature of business is not obvious. We think this situation adds to the importance of our company-specific analysis process.
- As we look to 2019, we are increasingly seeking either internet companies that have no real cyclical aspect in their business models and are not trading at excessive valuations, or company-specific opportunities where we think growth in revenue can accelerate because of reasons other than general economic factors.
- We believe there are potential opportunities in the life science tools and services industry both in the intermediate and long term. This industry provides the tools and services for research and manufacturing of new diagnostics and therapeutics to identify and treat human disease.
- An unprecedented number of innovative solutions are being tested for approval in humans globally and we expect this trend to continue, given the pace of scientific innovation. While slower global economic growth would have an impact, we still expect high-quality companies in the industry to grow. We tend to favor high-quality companies with lower relative valuations.
- The growth of life science companies has tended to be consistent and sustainable, which may be attractive in a volatile market.
Consumer discretionary, consumer staples
- We think U.S. consumer spending growth in 2019 is unlikely to repeat the rate of 2018. Globally, consumer trends are mixed, with Europe sluggish and China showing signs of slowing from very rapid growth rates in recent years. We believe any escalation of the trade dispute between the U.S. and China would have negative impacts to U.S. companies from higher costs on goods sourced in China, and could hurt consumer spending in both countries if there are price increases.
- We generally again look for high-quality companies in relatively less cyclical categories because of the potential trade issues. We tend to prefer good brands in strong categories with solid management teams, profitable business models and equity valuations that offer the potential for above-average shareholder returns over a multi-year period.
- In the U.S., retailers are facing headwinds, including wage inflation, rising freight costs and margin dilution from e-commerce. We think it will be a tough backdrop in 2019 for many retailers to grow “profit,” given these headwinds, although we think there may be opportunities in what we consider defensive areas such as off-price stores, auto parts, so-called “dollar” stores and discounters. We also think there are long-term growth drivers in the e-commerce and online retail segments.
- We think there will be potential opportunities in companies in the consumer staples sector, given its tendency toward a defensive nature. We think the market became overly concerned in 2018 about the pricing power of companies in this sector over fears of an inflationary environment and given the rise of online, private label and discount retailers. In 2019, we think companies with real innovations still can drive growth, and those with market positions in emerging markets may be somewhat insulated from broader headwinds and able to raise prices to support their margins.
- We expect 2019 to be a somewhat challenging year for the financials sector. In general, there are fears the U.S. is late in the economic cycle and Fed interest rate increases are becoming a headwind to U.S. bank margins. The flat yield curve also is a negative for profitability in the sector. The demand for credit remains strong, but there are market fears that it may not continue to grow.
- There is concern that the tailwind from strong equity and fixed-income markets may not continue, which could affect companies across the sector. For example, life insurance stocks are highly sensitive to bond yields and returns in equity markets. Volatility in the markets was a key headwind in 2018 and we think the uncertainties looking forward suggest similar pockets of volatility in 2019.
- Within the group, we believe exchanges are in the best position to benefit from market volatility again in 2019 because an increase in trading volume typically accompanies uncertain markets.
- After a strong start in 2018, industrials took a sharp downward turn due to the toxic combination of tariffs, increases in raw materials like steel and cooper, a stronger dollar and slowed growth in important end-markets, such as China and the eurozone.
- We believe these headwinds will continue to present challenges for companies across the sector at least through the first half of the year.
- However, we see are opportunities on a sub-industry level in an area like aerospace, which has proven to be less cyclical than other industrials over the last 15 years. We are intrigued by certain companies in this group as they are more focused on improving returns and margins than at any other point in recent memory.
- Volatility continues to be a key factor in the world oil market as well as the stocks of energy companies, and we think that is likely to continue in 2019. Strong supply/demand fundamentals deteriorated in the second half of 2018, as demand decelerated and supply was stronger than expected. On the supply side, OPEC nations began ramping up their production in expectation that Iranian exports would be eliminated in November by sanctions. However, the market was surprised when waivers for Iranian exports were granted by the U.S. This development, coupled with stronger than expected U.S. supply growth, lead to a large swing in the oil market to an oversupplied situation. In an effort to bring the market back into balance, OPEC and other nations, agreed to cut production by 1.2 million barrels per day (bpd) starting in January.
- The supply cut by OPEC is divided into two segments: a reduction of 800,000 bpd from OPEC members and a reduction of 400,000 bpd from non-OPEC partners, from an October 2018 baseline and effective January 2019 for a period of six months. OPEC will re-evaluate the situation in April 2019, which is also near the target date for the Iran export waivers to expire. The bulk of the total production cut is likely to come from Saudi Arabia. Russia is expected to represent at least half of the 400,000 bpd reduction from non-OPEC partners. Iran, Venezuela and Libya are exempt from the agreement and are not required to cut their oil output.
- We believe OPEC took a positive and necessary step toward rebalancing the world oil market with its decision and we think the move will help support prices in 2019. We believe that these supply cuts along with continued oil demand growth, despite somewhat slower global economic growth, will eventually lead to a balanced market in 2019.
- We also think OPEC’s decision gives U.S. exploration & production companies (E&Ps) the “all-clear” to continue maximizing oil production and taking market share, provided they have the cash flow. Therefore, we believe that U.S. oil output will remain very strong in 2019 at over 1 million bpd. The U.S. has been the main supplier of new capacity over the last five years, and this is likely to continue for the foreseeable future. Continued supply growth and drilling spend is likely to be a relative positive for E&Ps, oil services and refining companies operating in the U.S. Though U.S. onshore production will be the main source of new supply, there are also early signs of an international recovery with some longer-term projects getting funded in 2019.
As the economic cycle continues to mature, we are monitoring different factors from a fixed income standpoint. Notably, rising corporate leverage, historically tight credit spreads and continued flattening of the yield curve amidst rising rates are the most critical factors we continue to monitor and navigate. At this point in the cycle, and based on the factors below, we prefer higher quality credits that possess strong fundamentals, and are seeking to extend duration.
Over the last 10 years, the access to financing has been easy as companies sought financing at low rates. Since 2012, new issuance of investment grade debt has exceeded $1 trillion, and the three-year span from 2015-2017 saw new issuance of nearly $4 trillion. The most noticeable increase has been within the BBB-rated segment of the investment grade market. According to the Bloomberg Barclays indices, BBB credits as a percentage of the investment grade market have grown from below 30% in 2009 to approximately 43% of the investment grade market.1 While overall fundamentals remain positive, the expected slowdown in economic growth is a risk factor warranting close observation. Any sizable downgrade within BBB credits could raise concerns over the increased leverage we’ve seen over the past decade.
In addition, credit spreads narrowed considerably prior to the third quarter market volatility. In early October, the high yield index spread tightened to 316 bps, a decade low. In the weeks following, the uptick in market volatility drove spreads wider to approximately 440-450 basis points.2 We foresee credit spreads widening in 2019 as the markets evaluate earnings and profit growth in the corporate space.
We anticipate the U.S. dollar to soften in 2019 due to the Fed’s pause in rate hikes and slower domestic growth. However, the relative strength of the U.S. economy remains a tailwind for the dollar.
We believe a deal on Brexit is likely, which could signal a rise in interest rates by the Bank of England. Both of these events would support the U.K. pound, which is undervalued in our estimation.
We anticipate the yen and the euro to strengthen modestly throughout 2019, but expect to see continued currency depreciation with the yuan, as China continues to ease policy in an effort to stimulate growth.
1As of 11/30/2018, Bloomberg Barclays
2Federal Reserve Economic Data, ICE BofAML US High Yield Master II Option-Adjusted Spread.
2019 Outlook — What’s ahead amid slowing growth
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Past performance is not a guarantee of future results.Risk factos: Investment return and principal value will fluctuate, and it is possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of a fixed income security may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Investing in the energy sector can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments, and the cost assumed by energy companies in complying with environmental safety regulations. These and other risks are more fully described in a Fund’s prospectus.
The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through December 2018, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.