Any advisor who decided to sail around the world last January 1 and arrived home in early December might like what she saw in the financial markets over her absence. The first 11 months of 2018 saw an essentially flat S&P 500 in a year that had witnessed a 12% correction and a 16% rally. Throw in GDP growth of 2.9% or 3.0%, a 25% surge in corporate earnings and a contraction of price-to-earnings multiples from 18 to 15, and the advisor might think U.S. equities represent a bargain.

But appearances are often deceiving. Equities entered December after two months of surging volatility. As of this date, December 14, two-day swings of more than 1,000 points in the Dow Jones Industrial Average were becoming the norm. For the first time in a decade, the TINA (there is no alternative to stocks) argument was challenged as yields on cash approached that of stocks, while 10-year Treasury yields topped 3.0%.

After 2018 began with a rare period of synchronized global growth, expansion in many nations stalled out. By year-end, even the resilient U.S. was showing signs of moderating economic activity. In late November, Federal Reserve chairman Jerome Powell briefly calmed financial markets, modifying his language about future increases in the Fed funds rate and saying the current rate was “just under” neutral at 2.2%. On October 3, when that rate was at 2.18%, he had said it was a long way from neutral, revealing a swift change in his perception of economic strength.

Against that backdrop, other concerns surfaced in last year’s fourth quarter. Corporate debt levels have surged in recent years. On-again, off-again trade talks with China began to create bottlenecks in the global supply chain. Even an inversion in a miniscule part of the yield curve sent markets in a flutter. Finally, Brexit and other divisions in the European Union raised questions about the future of the euro.

All that said, many equity strategists are cautiously constructive about 2019. “Next year is going to be better than many think,” says Brad McMillan, chief investment officer at Commonwealth Financial Network. Equities will post an advance in the mid-single digits, he believes, while U.S. GDP should rise by about 2.0% or 2.25% in 2019. McMillan maintains that 2% is the sustainable long-term growth in a mature economy like the U.S.

Phil Orlando, chief equity strategist at Federated Investors, is more optimistic. Earlier in the year, his team at Federated thought the S&P 500 might end 2018 in the 3,100 area on its way to 3,500 by the end of 2019. Now they think 3,100 could be reached by this summer with the recent setbacks pushing back the 3,500 mark until sometime in 2020.

Orlando’s bull case rests on a number of factors. The labor and consumer markets are as strong as they have been in more than decade. Neither financial companies nor consumers are leveraged to the degree they were in previous cycles. In the postwar era, a recession has never started in the third year of a presidential cycle, when the S&P 500 is typically up about 20%, albeit with heightened volatility.

Most business and consumer confidence metrics are at or near cyclical or multi-cyclical peaks. Moreover, unemployment is at a 49-year low and wage growth is at a 10-year high, while lower gas prices are making people feel flush. Orlando thinks GDP growth will slow from 2.9% last year to a still-healthy 2.6% in 2019.

Are The Markets Sending A Message?

Clearly, not everything is sunny-side up, despite strong employment numbers. Saddled with $1.5 trillion in student debt, millennials aren’t buying houses in the way previous generations have.

Announced layoffs had averaged about 35,000 a month for most of the year, but in September through November they averaged 61,000. In a December webcast, DoubleLine CEO Jeffrey Gundlach observed that without a buildup in inventories, the 3.5% rise in 2018’s third quarter GDP would have been a meager 1.2%, indicating the U.S. was not immune to the global slowdown.

Negative news can feed on itself and become a self-fulfilling prophecy. That was evident when home builder Toll Brothers pinpointed “well-publicized reports of a housing slowdown” to explain poor financial results for its latest quarter.

But what some giant companies aren’t saying is equally significant. Apple told investors in October it would stop reporting unit sales of iPhones. It is highly improbable the company is doing that because sales are strong, says Kevin Landis, CIO of Firsthand Capital.

None of these events is cause for alarm, but some think the stock market is sending a signal that trouble is on the horizon. Like Orlando, Liz Ann Sonders, Charles Schwab’s chief equity strategist, has been eerily accurate for almost all of this decade-long bull market. In late October, she told advisors at the annual Schwab Impact conference that the odds of a bear market and a recession were rising. Trade tensions could tip the U.S. economy into recession faster than most people think, she said.

Crosscurrents in the financial markets provide good reason for advisors to reassess where things stand in the cycle after a decade of asset reflation. Take consumers out of the equation, and most of the U.S. economic data is decelerating, argues MFS’s global investment strategist Robert Almeida. Simply put, investors are receiving less compensation for risk than they got only a few years ago. He expects earnings to continue to moderate and doubts that the markets are prepared for that.

“Consensus numbers keep coming down,” Almeida continues. “At the individual company level, we expect to see more dispersion [of financial results].” In particular, there are worries that companies are driving high margins by using debt for non-core purposes like dividends and stock buybacks, which could hit investors with some downside surprises.

The Triple B Twilight Zone

Two years ago, debt levels were a conversation item in the MFS fixed-income department; today, the same conversation is occurring among the fund complex’s equity managers and analysts. “Highly leveraged companies struggled in 2007, and I’m anticipating something similar,” Almeida says. “The triple-B-rated [corporate debt market] has doubled in size from 10 years ago, and we could see some big stumbles in 2009.”

Concerns about corporate debt levels, which have doubled in the last decade, are growing. GE, GM and Ford are each carrying more than $100 billion in debt. AT&T has about $180 billion.

Rupal Bhansali, who runs global and international funds at Ariel Investments, thinks many investors are focused on the wrong problems. For several years, the market was worried about General Electric’s earnings, but “the big correction in its stock price has come about because of balance sheet risk,” Bhansali says. From General Electric’s underfunded pension, to the debt the company has assumed in order to maintain a lofty dividend, to the black hole created by the company’s insurance liabilities—the future of GE, an American icon, is now in question.

Triple-B-rated debt is in an extended twilight zone of its own, in Bhansali’s view, and she thinks many companies will experience difficulty. “We’ll start calling high yield ‘junk’ all over again,” she predicts.

How serious is the problem? “[Fed chairman] Powell said it doesn’t seem systemic,” noted PGIM Fixed Income senior portfolio manager Mike Collins. “It probably isn’t. But if enough issuers run into trouble, risk could be repriced.”

Therein lies the rub. Even if the problems are isolated and Wall Street banks and other financial institutions possess sound balance sheets, memories of 2008 linger. If companies get in a jam, Almeida questions whether these sources of credit will provide liquidity to the extent they once did.

How did major parts of corporate America get here? Between 2009 and 2012, many companies deleveraged and whipped their balance sheets into impressive shape.

By 2014, capital allocation had emerged as an issue of paramount importance in the boardroom. Most businesses had wrung all the value they could out of cost-cutting while sales had recovered nicely from their post-recession trough. So companies used their free cash flow for financial engineering activities like stock repurchases and dividend increases.

For growth companies in Silicon Valley, dividends and buybacks are sometimes seen as an act of surrender and an admission that a business has exhausted its imagination. For mature companies, shrinking the share float and lifting payouts may make sense. The problem arises when they borrow money for non-core purposes, as many have.

Ten years ago, triple-B debt represented 32% of all investment-grade debt; today it stands at 50%. That’s an increase from $715 billion to nearly $3.2 trillion, says Steven Romick, manager to the FPA Crescent Fund.

“Corporate debt has continued to deteriorate,” he says. “Certain overleveraged companies will have a tough time making it through the cycle.” Not surprisingly, Romick is avoiding high-yield bonds.

Reallocate To Value, International?

Speaking at Schwab Impact in late October, Jeffrey Kleintop, the giant firm’s chief international strategist, told advisors it was time to rebalance clients’ portfolios from domestic growth, which has outperformed for most of the decade, to international equities and domestic value stocks. If history is a good predictor of the future, Kleintop is certainly correct. The last time U.S. large-cap growth stocks outperformed by so much for so long ended in 2000, which was followed by the so-called Lost Decade.

Rob Arnott, non-executive chairman of Research Affiliates, thinks 2019 will be one of transition with possible recessions in pockets of the world rippling out from Europe. “You have fiscal policies all over the world focused on stimulus” at a time when global growth is moderating, he notes.

“It begs the question: Does stimulus really stimulate?” he continues. “Stimulating a mature economy is a good way to set it up for a steeper recession.”

The two big costs are increased debt and increased inflation, though the latter has failed to materialize despite the Herculean efforts of the planet’s central bankers. Thankfully, Arnott says, at least America’s Federal Reserve has built up a small store of dry powder to fight the next recession. Many other nations will have fewer options.

Like GMO’s Jeremy Grantham and many others, Arnott is confident that emerging market stocks will outperform America’s for the next five to seven years. “With a Shiller P/E ratio below 10, it is the closest thing to a bargain today,” Arnott says, explaining that in emerging markets one can buy half the world’s GDP at 9 times earnings. At that price, the fact that many emerging market stocks are government-owned enterprises that aren’t run to maximize shareholder value is baked into the price.

Others disagree. Bhansali maintains that emerging markets have been a “growth trap” for most of the last decade. “Going forward, they will be a value trap,” she argues. “The low P/E ratios are a head fake.”

Problems with emerging markets extend beyond governance and state-owned enterprise issues. Bhansali observes that a large portion of the companies in this asset class operate in commoditized industries that historically command low multiples like materials, mining and banks.

Bhansali notes that just when Europe was beginning to recover in 2015 and 2016, Brexit occurred, derailing the European recovery. Banks in Europe never recapitalized, and the stock price of the continent’s largest bank, Deutsche Bank, has been falling for years.

Rising Populism And Disruption

But there are definitely bigger issues to deal with when it comes to international investing besides bad banks and asset location. Ever since the Berlin Wall fell in 1989 and the U.S. Congress ratified NAFTA in 1993, the investing climate has been hardwired and optimized around an integrated world with limited constraints on the mobility of capital and labor, McMillan notes.

In recent years, an unmistakable backlash against globalization has swept the developed world. It’s not clear that this trend is permanent, but if the world becomes more nationalistic and countries organize their agenda around politics and not economics, that’s a huge change. “Global growth will likely be on a declining trajectory,” McMillan adds. Blaming the surge in populism on a handful of opportunistic politicians misses the reality of very real changes in the 21st century business environment. The rise of disruptive businesses has redefined the meaning of Benjamin Graham’s classic metric, the margin of safety.

David Giroux, T. Rowe Price’s chief investment officer and head of equity and multi-asset strategy, estimates that 30.6% of the S&P 500 is at risk for secular disruption. But the range could be anywhere from 20% to 35%.

Modeling this is extremely challenging. Take the asset management industry, which is being turned upside down by passive investing. If 30% of the S&P 500 is likely to be deleted from the index, merged into stronger businesses or marginalized into a shadow of what they once were (think of U.S. Steel, the world’s largest company 60 years ago), do people really want to place all their faith in index funds? At the same time, picking winners and losers also can be a perilous exercise.

To prove their own value in a world where a rising percentage of value stocks are secularly challenged, active managers will need to identify the next round of at-risk businesses before the market does, Giroux said at a November press event. Another of his takeaways is that the number of attractive industries and companies is shrinking. Inevitably, disruption will spawn a whole new generation of companies and industries, but in the last decade a growing number of these concerns have chosen to remain in private hands far longer than previous generations of start-ups have.

The Next Recession

The implications of disruption extend far beyond investing. Fewer and fewer workers have safe jobs.

At John Mauldin’s Strategic Investment Conference last March, Gundlach openly wondered about how voters around the world, who have elected a wave of angry populists in every continent during good economic times, would behave come the next recession.

Orlando thinks there’s a reasonable chance Democrats run the table in the 2020 election. The last time that happened was in 2008, and financial markets, which had nowhere to go but up, reflated for the next decade. But today’s world is a very different place, and so are today’s Democrats.

BlackRock, the world’s largest money manager, estimates the odds of a recession are only 19% in 2019, but thinks they will rise 38% in 2020 and 54% in 2021. Ironically, its research finds that in the calendar year preceding U.S. recessions since 1978, the S&P 500 has outperformed developed foreign markets, a 60/40 portfolio and U.S. Treasurys.

And several observers don’t see any recession on the horizon. Robert Browne, chief investment officer of Northern Trust, declared in late September that the odds of a recession in the next five years were less than 20%. His view is an outlier, and he acknowledges that the next five years could see rolling recessions in industries like energy, home building, retailing and many others, with some negative quarters of GDP sprinkled in along the way. And a profits recession like the one seen in 2015 is certainly in the cards.

Many like Gundlach and Arnott expect expensive homes in high-tax areas like New York, New Jersey, Connecticut and northern and southern California to be devastated as a result of the elimination of state and local tax deductions, but he isn’t predicting a recession. Some observers like PGIM Fixed Income’s Collins think the U.S. economy has already returned to the New Normal.

But other nations like Ireland and Australia have gone 15 years or more without a recession, and their economies aren’t nearly as diversified as America’s. The good news is that the Federal Reserve has more ammunition to anesthetize the next recession than the rest of the world. The bad news is that the world economy is still globalized, and many problems are likely to come from beyond our borders where we have little control.