Economic and Financial Market Review & Outlook-Winter 2019
January 28, 2019
- 2019 S&P 500 Index earnings growth estimate slows to 5% from 20% in 2018
- Failure to fully resolve trade issues remains a major overhang
- U.S. equity market valuation is less challenging now at 15.2 x 2019 earnings
- Expect slightly positive 2019 fixed income market returns as rising coupon income offsets modest capital declines
- Corporate bonds appear fairly valued as spreads are closer to average; Treasuries, Government Agencies, and CD’s more attractive
- Short to intermediate muni bonds make sense for high tax-bracket investors while TIPS have some appeal as an inflation hedge
- European Central Bank has curtailed quantitative easing, removing some liquidity
- Volatility returns as interest rates rise and liquidity is reduced (potential end of a Financial Repression)
- Dollar softens after a strong 2018 as foreign central banks attempt to reduce stimulus & Fed closer to end a tightening cycle
- U.S. political risk, especially concerning trade policy
- Geopolitical risk high around the globe; Europe, Middle East & East Asia are all vulnerable
- Wage gains accelerate toward 4% (versus current 3.2% Y/Y) resulting in faster pace of rate hikes
- Synchronization of monetary policy; foreign central banks become more restrictive
- Return of market volatility harms consumer confidence and consumption slows
- Increasing supply of U.S. Treasury debt disruptive to fixed income market
- Notable improvement in productivity allows for non-inflationary wage growth and higher profit margins
- Greater political stability in Europe
- Steadier exchange rates and commodity prices
- Trade issues recede as agreements reached
With apologies to Charles Dickens, 2018 was the “best of times and the worst of times”. The U.S. economy apparently grew at its fastest pace since 2005. (We don’t know for sure as the Bureau of Economic Analysis was shuttered due to the impasse in Washington, although the Bureau of Labor Statistics has remained open.) For the full year 2018, we estimate that GDP advanced just over 3%1. The S&P 500 index, on the other hand, fell by 4.4%2, posting its first negative return in a decade. Benchmarks for smaller capitalization stocks and foreign shares suffered double digit declines. Bonds managed to finish the year essentially flat, erasing earlier losses.
It is not unheard of for stocks to struggle during periods of strong growth, but such episodes are usually accompanied by accelerating inflation. Inflation was well behaved in 2018 with CPI rising just 1.9% year over year. Another possible cause is a deteriorating outlook, but 2018 appears to have concluded on a sound note, at least in the U.S. Consumer spending was strong through November, 2018. (December data is not yet available.) Further, the December employment report was arguably the best in the current cycle and an astonishing 2.6 million jobs were created for the full year3.
Given the economic momentum entering 2019, our expectation is that GDP growth should rise a healthy 2.5% this year1. Jobs remain abundant with the number of jobs outstripping the number of job seekers. Initial unemployment claims, a leading indicator, continue to hover near historic lows2. Given the strength of the labor market, and wage growth at a cycle high, incomes are likely to grow at a solid clip which should sustain a healthy increase in consumer spending. Facing a shortage of workers, growth in business investment should continue as companies spend on technology and automation.
Despite the healthy economic backdrop, market volatility is probably here to stay. Even under our positive scenario, growth will slow. The U.S. was booming and the Federal Reserve (the “Fed”) steadily raised interest rates. As a result, the dollar strengthened, and inflation moderated. We expect both the dollar and inflation to remain near their present levels. One of the disappointments of 2018 was that growth overseas softened. Tighter U.S. monetary policy presented problems for a number of emerging markets. Jitters over global growth and an over leveraged Chinese economy will persist and constitute a larger threat.
It is an understatement to say that economic policy is unsettled. Monetary policy is becoming more restrictive in the U.S. as the Fed hikes interest rates and also drains liquidity by reducing the size of its balance sheet. When interest rates were close to zero, there was no alternative to investment in equities and other risk assets. With Treasury bills now yielding 2.5%, some investors are starting to pull in their horns. Concern over the Fed making a policy mistake by tightening too much became extreme after some ill-advised comments, since walked back, by Chairman Jerome Powell. It seems likely that the Fed will raise the Fed Funds rate another one or two times in 2019 and declare that neutrality has been achieved, thus ending the tightening cycle.
Worries over monetary policy seem overdone. The Federal Reserve appears to be listening to the market and has, in fact, recently scaled back its projections for rate hikes this year, perhaps mindful of the flat yield curve. The last recession induced by the Fed’s interest rate policy dates back to 1982 when Paul Volcker intentionally decided to raise rates until inflation was broken. The subsequent three recessions stemming from the savings & loan crisis, dot.com bust, and the mortgage mess were more a result of financial bubbles and lack of regulatory oversight. There is no similar bubble currently in sight.
Negotiations with China over trade are another major overhang. The Trump administration has appeared overly fixated on the trade deficit while China has been unwilling to quit mercantilist policies inherent to its model of state capitalism. Tariffs may hurt China but offer no overall benefit to our economy. Both countries have much at stake. Because of the relative strength of our economy, the U.S. may currently have an advantage. Both sides have recently evinced hope that the talks are making progress. Geopolitical risk is high around the globe. The U.K. has not managed to come up with a suffplan for a smooth Brexit. Italy is battling with the Eurozone over the size of its deficit and its continued membership in the Eurozone is not entirely certain. Meanwhile the traditional flashpoints in the Korean Peninsula, the South China Sea and the Middle East remain. The U.S. suffered a record-breaking government shutdown at a time when a strong U.S. economy is more vital than ever for global growth. While the economic impact should be marginal, it hardly inspires confidence and the consensus view concerning the probability of a 2019 U.S. recession, while still low, stands at a six-year high of 25%2.
Given our confidence in the Fed’s management and our view that a constructive conclusion to the trade dispute with China and some resolution to the government shutdown is probable, 2019 should be reasonably constructive for investors. The overwrought pessimism of year-end 2018 created a better set up for equities, as valuations dropped to reasonable levels in line with the historical average. Washington Trust conservatively forecasts that S&P 500 Index earnings could grow by mid-single digits to $164 per share which produces a price/earnings ratio of 15.3X1. A 2019 total return in the high single digits appears achievable.
Bond returns will likely continue to be modest; interest income will again be required to offset losses to principal to generate a positive return. The yield on 10-year Treasury note collapsed from 3.25% in early November to 2.55% in late December as pessimism reigned but it has started to recover3. Importantly, credit spreads have recently narrowed, facilitating corporate bond issuance. We expect the yield to potentially rebound above 3% and for the yield curve to steepen modestly. Long-term inflationary expectations are likely to cycle higher to a more realistic 2%1. In the meantime, lower yields should provide a boost to a stagnant housing market.
The current economic expansion will celebrate its tenth anniversary in June and appears on track to become the longest on record. Investors have wondered for a good five years if we are in the 7th or 9th inning of the recovery. Who knows? Expansions do not die of old age. The longest professional baseball game lasted 33 innings (when the Pawtucket Red Sox triumphed 3 to 2 over the Rochester Red Wings). While there may be cause for concern over the 2020 outlook, it is too soon to tell. The data, however, clearly favor continued growth in 2019.
Sources: (1) Washington Trust Wealth Management; (2) Bloomberg; (3) US Bureau of Labor Statistics
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.