Stock Market Uncertainties Will Drive Intense Volatility in 2019 Unless…

Stock Market Uncertainties will Drive Intense Volatility in 2019 Unless...
iStock.com/Nuthawut Somsuk

Economic and Political Risk to Drive Trading in 2019

I’m glad to say “bon voyage” to 2018, as it was one of the most difficult times to invest in the stock market, with intraday volatility becoming the norm.

Now, I can’t say with confidence that things will be different in the stock market this year.

My targets for the stock market benchmarks in 2018 failed to materialize despite the euphoric start to the year, when the indices surged to just below my estimates in less than a month.

The early euphoric buying in the stock market that was triggered by the massive tax reform wasn’t sustainable.

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As we enter into the New Year, there are hopes for a fresh start for the stock market. But it won’t be easy.

China and Trade to Determine Direction in 2019

Entering 2018, I was concerned about the protectionist trade policies that saw tariffs placed on many countries.

The U.S. signed a trade deal with South Korea, but that was about it.

The big fear for investors was the tariffs placed on Chinese imports and the reciprocal tariffs.

Fast-forward nearly a year and the trade situation with China remains extremely uneasy, albeit there’s a window of negotiation extending to March 1.

There are scheduled meetings between some of the lower trade representatives during the week of January 7. But with China hawk Robert Lighthizer leading the U.S. trade delegation with China, it will not be easy to reach a deal unless President Donald Trump decides so.

Lighthizer is a hardened protectionist who opposed China’s inclusion to the World Trade Organization.

Peter Navarro, another China hawk, suggested a permanent deal would be difficult within the negotiation window.

And with the U.S. trade deficit surging to a 10-year high of $55.5 billion in October, including a record deficit of $43.1 billion with China, the route to a deal will be hard. And if there’s no China deal, it will likely be another messy year for the stock market.

Also consider that in addition to the current trade imbalance, the White House is targeting China’s rise in technology, specifically relating to the theft of intellectual property—a key taking point for a deal to happen.

It has become clear the U.S. wants to rein in some of China’s technological advances. This will make achieving a deal even more difficult, as I doubt China will want to significantly alter its plans. That said, there is speculation the country would slow down the pace and appease the U.S.

At the end of the day, China wants to reduce its dependence on U.S. and foreign technologies by developing its own advanced chips and other inputs.

The China risk will continue to hamper sustainable gains in the stock market, as traders will likely continue to take profits following strong rallies.

Given this, the first 60 days of the New Year will likely continue to see intense volatility in the stock market.

This reality makes forecasting targets for the stock market extremely difficult, as we saw in 2018.

In addition to the China risk, the stock market will need to consider the new Democrat-led House, which could make things much more difficult for President Trump. And this means stock market volatility.

For instance, the approval of “NAFTA 2.0,” the United States–Mexico–Canada Agreement (USMCA), will face some resistance in the Democrat House. Trump has threatened to dissolve the current NAFTA if the new trade deal is not approved by around June.

There are also trade deals to be made with the European Union, and so far, it doesn’t look like it’s a slam dunk. Add in the Brexit risk and its impact on Europe and you have even more stock market risk.

But with Trump needing trade wins and extending the economic renewal heading into late 2019 and into the election year in 2020, there is a good chance we will see progression.

Potential Slowdown on the Horizon

The fear is the continued escalation in the China trade war will negatively impact the global economies. The worst-case scenario is a slowing in the U.S. and global economies and the possibility of another recession in 2020.

U.S. gross domestic product (GDP) grew at 3.2% in the third quarter, but is expected to slow in 2019, depending on the macro situation.

China’s GDP was cut to 6.2% for 2019 versus the previous 6.5% projection.

The reality is that it has been 10 years since the recession in 2008, and if you believe in economic cycles, we are due for one.

We are already seeing large companies revise down their revenue and earnings guidance to reflect the environment of tariffs.

Of course, a slowing economy will impact corporate growth and translate into a shock to the stock market.

After earnings grew at over 20% for S&P 500 companies in the first three quarters of 2018, the macro risk has intensified and could lead to lower growth.

The Yield Curve Risk

The flattening of the yield curve and potential inversion is foreshadowing potential slowing and recession.

The yield on the 10-year Treasury is below three percent, indicating lower rates in the future due to the threat of slowing.

The Federal Reserve raised interest rates at the December Federal Open Market Committee meeting by 25 basis points. This move was expected, but catching the stock market by surprise was comments from Federal Reserve Chair Jerome Powell suggesting another potential two hikes in 2019. This was contrary to previous statements by Powell on adopting a “wait and see” approach. So now we could see another 50-basis-point increase in 2019.

In a sign of optimism, Federal Reserve Bank of New York President John Williams suggested that the rate policy may be reviewed if the economy slows in 2019.

Traders need to monitor the difference between the two-year and 10-year yields. The spread is at only about 12 basis points.

The fear is that the two-year yield rises above the 10-year yield—referred to as a “yield curve inversion”—a potential sign of economic slowing or a recession.

Chart courtesy of StockCharts.com

Recently, the stock market sold off after the yield on the three-year Treasury moved above the yield on the five-year Treasury.

We are also seeing China begin to dump some U.S. debt from its massive holding. Increased selling could pressure yields and rates in the U.S.

Charts Hint at More Uncertainty

As I suggested earlier, the direction of the stock market will largely depend on China and the global trade risk.

At this time, the technical picture for the stock market continues to have a bearish bias.

We saw an impressive one-day oversold bounce on December 26, when the Dow surged 1,086 points, while the Nasdaq jumped 5.84%. But it means little at this point.

Chart courtesy of StockCharts.com

The technical picture for the stock market continues to have a bearish bias.

The Russell 2000 remains in a bear market, while the Nasdaq, Dow Jones, and S&P 500 are hovering at around bear market territory. The Dow hit its lowest point since 2008.

Chart courtesy of StockCharts.com

The Dow, Nasdaq, S&P 500, and Russell 2000 are trading at below their key 50-day and 200-day moving averages.

Chart courtesy of StockCharts.com

December was nasty and set to record the biggest decline since the Great Recession. The nine-year-plus bull run appears to have ended or at least stalled and all four market indices are in correction territory.

The Nasdaq, Russell 2000, and S&P 500 are also displaying a bearish “death cross” formation—a sign for potentially further selling.

The market cap of the S&P 500 saw over $2.0 trillion in value vaporized in December. The spillover could impact the economy.

Chart courtesy of StockCharts.com

Investor sentiment is largely bearish for both the New York Stock Exchange and Nasdaq stocks. The sentiment needs to strengthen for any hope of a sustainable rally.

Chart courtesy of StockCharts.com

I expect the stock market volatility to drive trading as we near the March 1 deadline for some kind of trade framework. If this occurs, we could see another extension in the talks.

The problem is the lack of any uncertainty means an unhinged stock market.

Analyst Take

As I look forward into 2019, the idea of providing a sensible estimate for the stock market, given the current macro uncertainties, is somewhat fruitless.

In the best scenario, if a China deal is reached and the global economies don’t stall, we could see the major stock benchmarks rally 10%, and likely much more.

On the other hand, if no deal surfaces and the tariffs continue with China and other countries, we could see the stock market falter.

The scale of the potential stock market decline would depend on the impact on domestic and global economies. Some pundits have even suggested a possible stock market correction of 15% or more.

An economic slowdown could trigger a down year for the stock market and a move deeper into bear market territory.

My plan is to review the situation on an ongoing basis and generate a target for the indices if the macro risk stabilizes.