It’s one thing for Warren Buffett to say, as he famously did, that the key to good investing is to “be fearful when others are greedy and greedy when others are fearful”; It’s another thing to have the guts to do it. But if there was ever a time when markets smelled like fear, with a swift and indiscriminate shift to risk-off sentiment, it’s now.
After touching all-time highs just months ago, both the S&P 500 and the S&P/TSX composite index are ending 2018 in a tailspin, having plunged nine and 13 per cent into the red, respectively. In Europe and the U.K., things haven’t been much better, while in emerging markets, the bloodbath has been worse: the broad MSCI EM index has dropped more than 15 per cent in 2018, while China’s Shanghai composite lost nearly a quarter of its value.
In short, it has been a world of bad news. On those rare occasions when hope has managed to poke its head out of the gloom — the U.S.-China trade truce, for instance, reached at the G20 in early December — investors just haven’t been buying it.
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When fear proves this resilient, this accepted, it might be time to wonder whether a Buffett moment has arrived.
There are, after all, plenty of reasons for investors to consider being greedy heading into 2019 — you just have to look a little harder for them amid the recent losses.
For one, stocks are a lot cheaper now. Price-to-earnings is hardly a perfect valuation tool, but the changes in the P/E of the S&P 500 illustrate the trend. A year ago, it stood at just over 25 on a 12-month trailing earnings basis; today, it’s hovering around 20. One way to gauge whether or not that represents a “bargain” is to compare the inverse of the P/E — the so-called earnings yield — to the risk-free rate of a 10-year Treasury. Compared with a year ago, the differential between them has grown by 50 basis points, even as 10-year Treasury yields have increased. In other words, the risk premium for owning equities has gone up, suggesting that investors should be more fairly rewarded than they were a year ago.
And remember: “a year ago” was before the July-to-October run-up, which saw the S&P 500 rise by almost eight per cent. So stocks are cheaper than they were a year go, and even cheaper than they were three months ago.
Cheaper — but are they cheap? Buying into a down market is only a bargain if it doesn’t go (much) further down, and nobody wants to catch a falling knife. And the pessimism taking hold of markets is not irrational. The drivers of the equity selloff are clear and interrelated: the continuing trade war between the world’s two economic superpowers, taking place in the context of renascent protectionism around the world; rising concerns about slowing global growth; tightening financial conditions as monetary policymakers normalize rates and wind down quantitative easing; fears of a recession looming, as one part of the U.S. Treasury yield curve has inverted, which could be an indicator of a downturn to come.
Yet none of those is a done deal, and there are reasons for at least some optimism that they might not turn out as badly as feared.
One is that much of the uncertainty dogging markets now is coming from political instability — not just conflict, but unstable decision-making and the willing upset of the global economic system, largely but not solely at the hands of the United States. Whatever the sins of China on the trade front, U.S. President Donald Trump’s tariff war is simply bad economic policy, and his alienation of traditional strategic and economic allies only rubs salt into the wound to the international outlook.
But even here, there are signs of progress. The 90-day truce during which the U.S. pledged to refrain from elevating current tariff levels, as well as China’s concessions in cutting tariffs on U.S. auto imports and some recent pacifying rhetoric, suggests there is room for movement on both sides. While both Trump and China’s Xi Jinping have bases to appease — and being tough on each other is one way to do that — they also have political reasons to work toward a deal.
Xi was already facing slower growth as Beijing tried to wean the economy off debt and transform it towards consumption; the trade war has only made that more complicated, and no doubt China would like to see it go away. Meanwhile, Trump now faces a House of Representatives under Democratic control; his levers to juice the U.S. economy and the markets are now very limited. But he could end the trade war with the stroke of a pen. As the next election cycle begins, he can still claim he’s been a good (no longer great) president for the stock market, with the S&P 500 up about 15 per cent since his election in November 2016. But if the trade war bites further into global growth and U.S. equity valuations, he might have to change his tune on tariffs, especially if the economy slows down, as expected. He might even come around to the view that there are better, less confrontational and expensive ways to sway China toward reform.
Of course, Trump could just continue what he’s been doing so far, and scapegoat Jerome Powell and the Federal Reserve for the market downturn and slowing economy. To some extent, Trump is right: higher rates are undoubtedly pinching economic growth. The Fed raised rates again in its December meeting — a sign, perhaps, that it will not be swayed by Trump’s critical tweets or by market volatility. But importantly, it also lowered its hints on rate increases next year — implying two rather than three — and added a “some” to the now well-worn phrase “further gradual increases” in the Federal Open Market Committee statement.
That suggests the Fed is getting closer to what it sees as a neutral rate, setting the stage for at least a pause in its tightening path next year. Notably, the U.S. dollar responded to the downside after the Fed meeting — which, by the way, is good news for emerging markets, which rose. If the central bank sends more dovish signals as it nears neutral, EM stocks could be among the earliest and biggest beneficiaries.
As for fears of recession, it’s true that every time the Fed hikes, the risk of an overshoot increases. But at the moment, there are few real signs of an imminent downturn in the world’s biggest economy. Yes, this expansion has been a long one, but there’s no law that it has to end at any given time. In the U.S., employment remains strong, GDP growth is solid, and inflation is still stuck at around two per cent (another headwind for higher rates). The two-year/five-year Treasury yield curve has inverted, but the further ends of the curve, which are traditionally more reliable indicators of recession, haven’t — yet. And it’s not clear that they will, especially if the Fed starts to punctuate its hiking path with a break or two (or three) next year.
Even if there is a recession, then it’s worth considering how bad it will really be. There seems to be no systemic vulnerability in the global economy right now. Unlike the last time around, there is no real estate bubble or household debt crisis in the U.S. (Canada is a different matter, and we could be much more vulnerable to monetary policy error than the U.S. is.) The global financial system is better capitalized and less exposed to risk, and governments and regulators seem better positioned to contain contagion from local breakdowns. In short, if there is a global recession coming, it’s hard to see where it will come from — which is not to say that it won’t happen. But if there is one, the chances seem good that it will be both brief and mild.
So, optimists, take heart: 2019 might not exactly be good for investors, but it could very well turn out to be less bad than the ugly markets of 2018 are letting on.