2019 Investment Outlook - USAA

2019 Investment Outlook

By John C. Spear, CFA, USAA Mutual Funds Chief Investment Officer

USAA MARKET COMMENTARY -- 12/19/18

If there had been any remaining doubts that monetary policy and the U.S.China trade dispute are the most potent issues facing asset markets as we head into 2019, the past few weeks of ups and downs should put those doubts to rest.

Stocks jumped in late November after Federal Reserve chair Jerome Powell indicated in late November that rates are now near neutral -- neither helping nor hindering the economy -- and that the central bank may slow its pace on rate hikes in 2019.

Those gains were erased within a few days when a top Chinese tech executive was arrested on a U.S. warrant. But then another big upswing when Beijing offered to buy more U.S. farm products and slash tariffs on American cars, and another drop on weak GDP data from China and the European Central Bank's decision to tighten its money supply.

Underlying the market swings are worries about a softening global economy that could get even softer if interest rates rise too high or there's too much more disruption to trade relationships.

And underlying the worries about global growth is the biggest worry of all -- that a recession may be lurking around the corner.

Adding to the recession fears is the Treasury yield curve -- as of midDecember, the yield on a 2-year government bond was only slightly lower than the yield on a 10-year bond, the result of nervous investors seeking safety from riskier assets. This type of flattening has often been a precursor to a yield-curve inversion (2-year yield above the 10-year yield). Each of the U.S. recessions since the mid-1950s has been preceded by an inverted yield curve.

Will there be a 2019 recession that ends one of the longest periods of economic expansion in U.S. history? We don't see it happening for a couple of key reasons.

First, though there are signs that the trade standoff with China is starting to hurt some industries, the U.S. economy has been holding up well at 3+% real growth. U.S. GDP momentum is expected to lose some steam in 2019 as the stimulative effects of tax reform, regulatory easing and higher government spending continue to fade, but slower growth is a far cry from economic contraction.

USAA Market Commentary -- 12/19/18

OVERVIEW

? In 2019, we expect a

continuation of the volatility spikes that have defined market behavior over the past few months. The pace of the Federal Reserve rate hikes and U.S.-China trade are likely to be the key drivers.

? Underlying the market's

turmoil are worries about slowing global economic growth. U.S. GDP is likely to grow at a lesser clip in 2019 as fiscal and monetary stimulants wear off, but we don't foresee a slide into recession.

? On U.S. stocks, our focus

on valuations provides some optimism for 2019, while high debt and lower quality may weigh on U.S. credit. It's hard to get too excited about overseas equities in the short term, but they remain a longerterm opportunity.

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And second, while an inverted yield curve has been a reliable indicator of a coming recession, the lag between the two events has been far less consistent. Over the past six decades, the time between inversion and recession has ranged between six months and two years. This brings us back to the first point -- aside from the yield curve, recession indicators are scarce.

Of course, if the Fed leans unexpectedly hard into rate hikes or if the global trade regime completely unravels, we would have to revisit our position. In any event, given how much markets hate uncertainty, there is one thing we should expect in 2019 -- more of the same volatility that has defined the late months of 2018.

FIGURE 1

2018 PERFORMANCE BY ASSET CLASS

TOTAL RETURN THROUGH NOVEMBER 30

U.S. Large Cap Equity

5.1%

Small Cap Equity

1.0%

Municipal Bonds

0.1%

High Yield Bonds

0.1%

U.S. Aggregate Bond

-1.8%

10-Year Treasury

-3.4%

Commodities

-4.7%

EM Bond

-6.8%

EAFE Equity

-9.0%

Emerging Markets Equity

-12.0%

-12.5%

-10%

-7.5%

-5%

-2.5%

0%

2.5%

5%

7.5%

Indexes used: Russell 2000, Standard & Poor's 500, Bloomberg U.S. Corporate High Yield Bond, Bloomberg Barclays US Credit Index, Barclays Bloomberg Municipal Bond, MSCI EAFE, Barclays Bloomberg U.S. Aggregate Bond, U.S. Benchmark 10-Year Govt, JP Morgan EMBI+ Index, MSCI Emerging Markets

Source: Thomson Reuters Datastream as of 9/30/2018

ASSET CLASS OUTLOOK

How tough has 2018 been for investors? At this time last year, every key asset class was positive and each was doing better than this year's best performer -- U.S. large caps, which in mid-December were barely in the black on a total return basis.

Since early fall, uncertainties about interest rates and the global trade regime had been amplifying investor worries about slower economic growth. Markets appear to have moved from deep pessimism to skeptical but open to persuasion as bits of good news trickle into the markets -- a welcome shift along the confidence continuum, however modest it may be.

Some high-level thoughts about 2019 for key asset classes:

U.S. EQUITIES

The sharp volatility spikes in U.S. stocks in recent months have brought out the doomsayers, but absent a catastrophic turn in the U.S.-China trade dispute or a Fed-forced upward march in interest rates, we have a hard time joining their bleak outlook for 2019.

USAA Market Commentary -- 12/19/18

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But at the same time, we cannot at this point get behind the bold bulls who expect the S&P 500 to be 15%-20% higher by this time next year.

Our focus on valuations provides some optimism for the coming year. After years of concern about stretched price multiples, the combination of 2018's strong earnings growth and the late-year market pullback make for more attractive fundamentals -- the 12-month forward P/E for the S&P 500 is a little above 15x, well below its five-year average. We think there's room for the P/E multiple to expand in 2019 as share prices catch up to revenue and earnings gains.

U.S. BONDS

After dwelling among the worst performers for most of 2018, long-dated Treasuries rallied late in the year. Several factors fueled the bond price jump, among them a safe-haven rush away from gyrating stocks and a Fed signal that interest rates may be close to neutral.

Expectations of Treasury yields going nowhere but up appear to be dashed for now -- fewer rate moves by the Fed in 2019 looks likely given mounting worries about slower economic growth ahead. This could support Treasury prices.

FIGURE 2

CREDIT QUALITY SHOWS DETERIORATION OVER TIME

INVESTMENT-GRADE CORPORATE BONDS BY RATING, 1988-2018

AAAAAABBB

100%

80%

60%

40%

20%

0%

1988

1993

1998

2003

2008

2013

2018

Chart depicts IG corporate bond component of Bloomberg Barclays U.S. Aggregate Bond Index|Source: Bloomberg Barclays Indices

Prospects of slower GDP growth, stock-market strife and high debt loads are weighing on corporate bonds, and this will likely continue in the coming year. Of particular concern: BBB bonds, the lowest IG rating, now comprise close to half of the market (Figure 2). Any downgrades could be to high-yield status. We are now more focused on quality, as we see less compensation for taking more credit risk.

USAA Market Commentary -- 12/19/18

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DEVELOPED MARKETS

It's hard to get too excited about non-U.S. developed markets when looking at the near term -- gone is the promising period of synchronized global growth, which petered out in early 2018. Japan fell off most abruptly, reflecting its heavy reliance on supply chains imperiled by the U.S.-China trade dispute. In Germany, the economic engine of Europe, exports are down and so is consumer confidence.

Europe's political environment is also challenging, which makes it all the more surprising that we're seeing opportunity in Britain in the form of attractive valuations and strong earnings growth. How long this opportunity lasts will be to a large extent dependent on how the Brexit issue is settled.

FIGURE 3

NON-U.S. DEVELOPED ATTRACTIVE ON VALUATION BASIS

MSCI EAFE P/E RELATIVE TO MSCI USA (IN STANDARD DEVIATIONS)

DM Valuations < U.S.DM Valuations > U.S.

3

2

1

0

-1

-2

-3

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

P/E = Price-to-earnings ratio|Source: Thomson Reuters Datastream

Developed markets are significantly undervalued compared to the U.S. -- the forward P/E ratio for DM is now about 1.5 standard deviations below the long-term average (Figure 3). Earnings growth for the two asset classes is expected to be more comparable in 2019, which could enhance the appeal of the undervalued DM shares.

EMERGING MARKETS

Long before the U.S.-China trade issue developed into a leading threat to global growth, the threats and counterthreats out of Washington and Beijing (along with Fed tightening) were exacting a harsh toll on emerging markets. In early April, EM was the top-performing equity asset class -- by June, it was by far the worst.

This sensitivity to trade disruption affecting China works the other way as well -- the late-year progress toward a deal provided more lift for EM than other markets, an indication that more upside may lie ahead in 2019 if the trade issue is settled, the Fed slow-walks rates and the U.S. dollar continues to level off.

USAA Market Commentary -- 12/19/18

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Already we're seeing a bit more optimism out of EM that economic conditions are improving (Figure 4). With U.S. GDP growth expected to dip in 2019, the 6+% growth envisioned from China, India and across much of Asia looks all the better. In our view, EM remains a long-term relative valuation opportunity that could provide a bumpy ride over the short term.

FIGURE 4

ECONOMIC OPTIMISM ON UPSWING FOR EMERGING MARKETS

PURCHASING MANAGERS INDEX (COMPOSITE)

EM PMIU.S. PMI

58

56

54

52

50

48 2016

2017

2018

Reading over 50 indicates economic expansion; under 50 indicates contraction.|Source: Bloomberg as of 11/30/18

COMMODITIES

As with other asset classes, the outlook for commodities hinges to a large extent on Federal Reserve policy moves and the U.S.-China trade conflict.

A Fed less aggressive on interest rates in 2019 stands to be demand-positive for oil and other commodities priced in dollars, as rising rates have been a key dollar driver. But oil producers also have a persistent oversupply problem -- even with the latest agreement by OPEC, Russia and others to cut output, an ongoing glut is forecast for 2019.

China is the world's leading market for industrial metals and a major importer of oil and agricultural products, so economic slowing in China due to U.S. trade impediments have presented headwinds for these commodities. We would expect this to continue into the coming year, at least until any trade deal is reached.

USAA Market Commentary -- 12/19/18

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Investing in securities products involves risk, including possible loss of principal. This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisors. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy or investment product. The views and opinions expressed in the material solely reflect the judgment of the authors, but not necessarily those of AMCO, IMCO or any affiliates as of the date provided and are subject to change at any time. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA. Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income. Past performance is no guarantee of future results. Asset allocation does not protect against a loss or guarantee that an investor's goal will be met.

Fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss. Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability.

Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

The MSCI EAFE Index covers 21 developed markets outside of North America: Europe, Australasia and the Far East. It aims to include in its international indices 85% of the free float-adjusted market capitalization in each industry group within each country.

The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the U.S. equity market. The index covers approximately 85% of the free float-adjusted market capitalization in the U.S.

The Bloomberg Barclays U.S. Municipal Bond Index covers the U.S. dollar-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds.

The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the U.S. dollar-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.

The Standard & Poor's 500 Index is an unmanaged index of 500 stocks representing the large cap segment of the market, covering 75% of the U.S. equities market.

The Russell 2000 Index is an unmanaged index that consists of the 2,000 smallest companies in the Russell 3000 Index. It is a widely recognized small cap index.

The Bloomberg Barclays U.S. Aggregate Bond Index is a widely recognized index used to track the performance of investment grade bonds in the U.S.

The Bloomberg Commodity Total Return Index is composed of futures contracts on physical commodities. It reflects the combined returns of the Bloomberg Commodity Index and cash invested in short-term Treasury bills.

The JP Morgan Emerging Markets Bond Index Plus (EMBI+) tracks total returns for foreign currency-denominated, fixed-income securities issued in emerging markets.

Purchasing Managers' Index is a survey-based indicator of economic health for manufacturing and service sectors. A PMI above 50 represents an expansion when compared with the previous month. A PMI reading under 50 represents a contraction.

CFA? and Chartered Financial Analyst? are registered trademarks owned by CFA Institute.

Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers, and affiliates.

USAA Investments is the marketing name for USAA Investment Management Company.

?2018 USAA. 258343-1218

USAA Market Commentary -- 12/19/18

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