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Investors bracing for more turbulence for US markets in 2019

U.S. investors are struggling to decide how to structure their portfolios heading into 2019 as the country's continuing trade tensions with China and uncertainty over the pace of Federal Reserve interest rate hikes are creating an increasingly cloudy outlook for the domestic economy.

Volatility returned to equities in 2018 following years of loose monetary conditions fueling asset prices. The S&P 500 has shed 15.7% since its Oct. 3 peak of 2,925.51 and sentiment is bearish.

"Those investors who were reluctantly long in 2018 may decide that it will pay to dance closer to the door in 2019 in the event there is a stampede for the exit. As a result, periodic bouts of market volatility can be expected to emerge in a market environment which is likely to remain on edge," wrote Peter Dixon, global financial economist at Commerzbank, in a recent note.

Dixon pointed to the beginning of the trade dispute between the U.S. and China earlier in the year as the catalyst for investors to reassess market fundamentals and identify a broader set of problems. "I would argue that markets have been living off thin air to a large extent in 2018," he said, noting that cheap credit had wiped out much of the normal risk premium.

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Market uncertainty about Fed

The U.S. Federal Reserve has now increased interest rates on nine occasions in the past three years — with Dec. 19's hike the most recent — while shedding $50 billion a month from its balance sheet as it reverses years of loose monetary policy. The key debate among investors is how much further will the Fed go with its hiking policy in order to reach a neutral rate.

The central bank's dot plot, which indicates the expectations of Fed board members, suggests there will be a further two rate hikes in 2019 and one more in 2020, yet investors appear skeptical.

"The U.S. Treasury yield curve is not pricing this interest rate profile, instead reflecting the fears that are affecting markets rather than the statements and guidance from the central bank. Not even one more rate increase is priced in," said Sandra Holdsworth, head of rates at Kames Capital.

Read more: Drop in bond yields reignites inverted curve fears

"Doubts about how far the Fed can 'normalize' its balance sheet persist," said Paul Della Guardia, a financial economist at the Institute of International Finance, in a research note. "These uncertainties suggest that higher market volatility may become a new normal, even if economic data remain benign."

Flight to safety

Rising interest rates and a ballooning fiscal deficit — expected to exceed $1 trillion in 2019, according to the Congressional Budget Office would typically result in rising yields on sovereign bonds. But yields on 10-year Treasury notes, having steadily risen through the year to a peak of 3.24% on Nov. 8, dropped to 2.79% as of 07:55 a.m ET on Dec. 21, as investors look for safe assets to buy.

Mark Holman, CEO of asset management company TwentyFour AM, expects Treasury yields to continue weakening in the months ahead as money shifts from equity markets. "We think investors are broadly carrying too much risk into what they think may be a slowdown; they have been dumping risk assets, and simultaneously buying more ‘risk-free’ assets such as US Treasuries," he wrote in a research note.

Concerns are building that with no tax cuts in 2019 to support profits as there had been in 2018, stocks are overvalued. "Equity market valuations remain out of line with fundamentally-justified levels. Moreover, U.S. markets are overly dependent on tech stocks," Commerzbank's Dixon said. "It is becoming ever more difficult to find value."

Building a wall with China

Talks between the U.S. and China were extended for a further 90 days at the G20 meeting held from Nov. 30 in Buenos Aires as U.S. President Donald Trump signaled "a big leap forward" in finalizing a deal. The market enjoyed a jolt as a result, with the S&P 500 ending 1.1% higher at 2.790,37 on Dec. 3. But investor enthusiasm evaporated as it became clear that nothing had yet been agreed. China's subsequent confirmation that tariffs on imports of U.S. cars will be temporarily suspended made little impact on the S&P 500.

"I don't think we're going to get a quick or a full resolution," said Leah Traub, a partner and portfolio manager for taxable fixed income at Lord Abbett & Co. LLC, of the trade tensions, at a recent conference in London.

The Dec. 1 arrest in Canada of the CFO of Chinese tech giant Huawei at the request of the U.S. triggered a further slump in stocks, as investors lost confidence in a de-escalation of tensions between China and the U.S. Traub sees the possibility of smaller trade deals, but not a definitive conclusion to the dispute, which will "ebb and flow" for a while.

"I do think the volatility is still going to be with us," she said. "I don't think we're going to get a quick or a full resolution."