A long chairlift ride in the Swiss Alps allows time to ponder how the recent market-friendly policymaker comments have been a lot like the snow reports skiers crave. A forecast for snow is great, but you never know how much snow you are going to get, nor how long it will last. In the following article, we discuss our current market outlook in the context of both upside and downside risks present.
2019 has seen the best start to the year for global equities since 1991. Equity momentum is strong, volatility has declined below its long-term average, and markets are now back to levels last seen prior to the December sell-off. That's on the back of a more dovish tilt from the Fed, credit expansion in China, and more optimism surrounding US-China trade talks.
The question now is whether valuation multiples can still expand given that some good news has been priced in, yet a number of key market risks remain.
On the upside
For now, we believe the current backdrop for stocks remains supportive and still see several factors that could drive further upside:
Among the best things that investors can hope for in the months ahead is that nothing happens.
Growth is neither so bad that corporate profits are falling, nor so good that inflation and interest rates are being driven higher.
Constructive talks between the US and China have helped kick tariffs down the road, and our base case is that this will happen again prior to the scheduled tariff hike on 1 March.
While currently the 12-month-trailing price-to-earnings ratio for the S&P 500 is around 17x, only slightly higher than its average since 1960, it often moves higher when the Misery Index – the inflation rate plus the unemployment rate – has been less than 6.5%.
We cannot rule out the possibility of a positive, unanticipated shock, such as long-term US-China trade resolution. Such a development could push markets well above October highs.
What we’re watching
To be sure economic data has weakened since the fall, most notably in China and Europe, where the decline started as early as last spring. We will be watching closely for signs that the recovery is materializing and are monitoring a number of risk scenarios to our positive base case:
The worst market reaction to a Fed rate hike since 1994 in December has been followed by a rally as the Fed has adopted a more dovish stance.
US – Is the Fed getting it right?
We will continue to watch growth and inflation indicators closely. Core PCE, is tracking just below the central bank’s 2% annual target. With unemployment at just 4.0%, and average hourly earnings increasing 3.2% year-over-year, it won’t take much for the Fed’s stance to become more hawkish again. On the other hand, the tight labor market, current inflation picture, and and the Fed's self-avowed “data dependence” make it less likely that it will surprise the market with preemptive cuts should the economic picture weaken marginally.
China – Will stimulus prove sufficient?
China’s economic data year-to-date has been muted. Accommodative fiscal and monetary policy measures should help spur growth and Chinese credit growth data for January suggests that monetary policy easing may be starting to gain traction. But the outcome of US–China trade talks will also be important for the economic and market picture.
Europe – One-offs or a cyclical slowdown?
It is now close to a year since the European Central Bank first highlighted that Europe was undergoing a “temporary slowdown." One year on, the slowdown is starting to look more chronic than acute. While some signs of improvement have started to surface, we will be watching the data to see if this recovery materializes. European policymakers don't have a lot of scope to support growth through official policy and a hard Brexit also remains an outside risk factor to watch.
Tactical asset allocation
Balancing upside and downside probabilities after the recent market move, we think the risk return outlook remains favorable and maintain an overweight to equities. However, we also hold certain positions to protect against a more uncertain environment and the downside risks outlined above.
Visit the preferences tab for a full list of asset class views
Read the full monthly letter by UBS Chief Investment Office