HIGHLIGHTS:
Summary
The economic outlook: Slower but above-trend growth.
Earnings growth should to continue but at a slower rate.
The FOMC expects fewer interest rate hikes in 2019.
Limited legislation is expected from Washington, but lots of noise.
Progress on trade is perhaps the key variable for 2019.
Via Nova’s outlook is positive, but risks remain and will have to be monitored carefully.
Summary:
Via Nova believes the U.S. economic expansion will achieve a new longevity record in 2019, and corporate profits will rise, creating a favorable environment for higher stock prices. Bond yields are likely to rise more slowly than in 2018. However, against that likely setting of stronger sales and more attractive valuations, the policy and political climate could continue to keep investors on edge and market volatility high. We believe policy mistakes and miscalculations – self-inflicted wounds - not only in Washington but around the world, represent the biggest threat to the outlook.
The following paragraphs summarize Via Nova’s expectations for the economy, corporate profits, and interest rate policy. Trade policy and political posturing, perhaps the most challenging area for analysis, will also be discussed. Finally, we will outline some of the risks that could affect the outlook. The “wall of worry” for investors is high, based on the difficult market throughout 2018 and especially the fourth quarter. However, when worries are high, and fear abounds, the opportunity for positive market surprises improves. We believe discipline and patience are keys to success in the coming year.
The economic outlook: Slower but above-trend growth.
The U.S. economy has been strong in 2018 along a broad front. Growth, as measured by inflation-adjusted GDP, increased at an above-trend rate powered by a stronger consumer. The unemployment rate has fallen to a five-decade low. Consumer incomes are rising, and confidence is high. It is not surprising that holiday sales have exceeded expectations, which is positive for company sales and profits. Government spending has also increased at the federal level as well as at the state and local level. Tax cuts and fiscal stimulus have clearly played a role in the growth acceleration, but improved fundamentals have also been keys to the advance.
However, not all areas of the economy have shown consistent gains. Housing activity has been on a downward slide in 2018, in part due to rising mortgage rates, and business investment appears to have slowed some, perhaps due to trade uncertainty. Despite efforts to reduce the trade deficit in 2018, the deficit has increased as businesses bought products in advance of tariff increases and slowing overseas growth crimped demand. Higher trade deficits subtract from total growth. This irregular spending pattern could introduce an additional element of volatility to the monthly business statistics in 2019.
Looking ahead to the coming year, Via Nova expects the current economic expansion will continue and hit a new longevity record. However, the pace of growth is likely to slow from roughly 3% to 2½%, which is still above-trend. The economic gains should be powered primarily by a healthy consumer and government spending. Trade could be a net drag over the near term as might business investment if trade tensions escalate. Inflation has surprised to the lower side in 2018 and will likely remain subdued in the coming year, especially given the recent decline in energy prices.
The prospects for foreign economies are less upbeat, which could curb demand for U.S. exports. Momentum slowed through much of the EU and China in 2018, and Brexit left many companies in a heightened state of uncertainty. Despite the weaker outlook for the EU, central bankers recently decided to end their bond purchase program – adding to economic headwinds - though they will keep interest rates low for the time being. Most forecasters have lowered growth expectations for 2019 in the wake of these risks.
Earnings growth should to continue but at a slower rate.
The outlook for corporate earnings growth is good, but there are risks. After increasing by a very strong 20% in 2018, based on the latest estimates, earnings are projected to grow by another 9% in 2019. In all fairness, analysts tend to be an optimistic crowd, and they often overestimate profits growth. However, even if we adjust for historical misses, S&P 500 earnings should still hit record highs in the coming year.
There are several factors that could impact corporate earnings and revenue growth expectations. One is the recent strength in the U.S. dollar, which makes exports more expensive to foreign buyers. A second factor is rising costs, such as wages, which could lower profit margins. Rising interest rates remain a risk and would increase the cost of capital and debt servicing. Slower international growth, already mentioned, could have a negative impact on companies with significant export exposure. Last, but not least, is the risk of escalating tariffs. Most companies report that current tariffs are manageable, but risks mount if tariffs continue to rise. Analysts and investors have not been blind to these risks, and in our view, stock prices already reflect much of the uncertainty. It should be pointed out, of course, that all the above risks could become tailwinds if the pressures ease or reverse.
The FOMC expects fewer interest rate hikes in 2019.
Via Nova believes the Federal Reserve will move more carefully and cautiously in raising interest rates in 2019, which could be relatively positive for both stocks and bonds. We believe there could be two or fewer rate increases over the coming year, down from four projected earlier in the year. The reason is that the economic and market volatility of 2018 has not gone unnoticed by the Federal Reserve in setting interest rate policy. At its December meeting, the Federal Open Market Committee (FOMC) raised short term interest rates by a quarter percent to a range of 2¼%-2½%, as expected. However, the FOMC pared back its own expectations for future moves, and slightly lowered its forecast for growth and inflation in 2019, reflecting the heightened risks. The five previous FOMC meetings’ statements included the simple sentence, “Risks to the economic outlook appear roughly balanced.” But at the conclusion of this latest meeting, the statement read, “The Committee judges that the risks to the economic outlook are roughly balanced but will continue to monitor global economic and financial developments and assess their implications for the economic outlook.” The FOMC appears to understand that it can significantly influence economic momentum and market volatility.
Limited legislation is expected from Washington, but lots of noise.
Via Nova believes few major pieces of legislation will pass over the coming year, as both parties begin to gear up for the 2020 Presidential race. Some areas of common interest include infrastructure spending and possibly tweaks to health care. The new Democratic majority in the House is likely to assert its voice on many spending priorities and will likely hold several inquiries into the conduct of President Trump. Impeachment proceedings should not be ruled out, but in our view, the chance of removing the President from office is extremely low, given that it would have to be approved in the Republican-controlled Senate. However, the Senate may make substantial progress in approving a number of relatively conservative and business-friendly judges.
Still, the actions in Washington will likely generate a lot of press coverage and add to market volatility. The government shutdown in late December was disappointing but not surprising. Via Nova does not see government bond defaults or funding for key needs such as defense or entitlements as a major risk, but the shutdown is symptomatic of a Congress that is more focused on political advantage than the progress that comes with consensus.
Progress on trade is perhaps the key variable for 2019.
While trade and Federal Reserve interest rate policy were the dual risks in 2018, the critical focus in 2019 will likely center on trade. The tough trade talk in early 2018 resulted in some revised trade agreements with Canada, Mexico and South Korea, but progress with China, the second largest economy, bogged down and escalated leading to the imposition of tariffs. There have been some signs of cooperation in recent weeks, and the two parties are expected to convene in January. If the U.S. and China can find a way to diffuse the situation and still save face, it will be a significant positive for the equity markets, both domestically and internationally. If not, trade tensions could escalate to potentially dangerous levels that would be negative for all parties and all markets.
Via Nova’s outlook is positive, but risks remain and will have to be monitored carefully.
Via Nova’s most likely scenario is that the economy and corporate profits will continue to grow in 2019, and equity prices will likely move higher, especially given the more attractive valuations. Bond yields could rise further, but the continued low level of inflation and more dovish comments from the Federal Reserve suggest that the bulk of the interest rate rise is behind us, for now.
However, the coming year is filled with risks and uncertainties. Most of these adverse risks are related to potential political and policy mistakes and would be self-inflicted. At the top of the list is trade negotiations with China. The gradual alignment of the west on trade concerns with China is an important positive. Failure to reach an agreement would likely result in higher tariffs, lower growth overseas, and rising inflation pressures here at home. No one wins a trade war, but the correction of trade abuses is critical to trade growth.
Political risks abound as Congress reconvenes with a Democratically-controlled House. Our view is that polarization has never been higher, and there seems to be little interest in finding the common ground necessary for progress on many important issues. The best possible outcome, unfortunately, is gridlock. Candidates have already begun lining up for the 2020 Presidential election, which tells us the polarization will likely intensify.
The slide in oil prices has been a net positive for consumers so far, but a more significant decline could lead to fresh layoffs in the domestic oil industry. Another risk is that the FOMC will decide to continue “normalizing” interest rates. The slate of 2019 FOMC voters appear to be more hawkish, leaning toward higher rates. Other risks include geopolitical uncertainty, especially in the Middle East.
Via Nova believes these risks can be managed, which would allow investors to refocus on the favorable fundamentals of economic, sales and earnings growth – all of which should be supportive of higher stock prices. That said, we will continuously monitor both the positive trends and risks over the coming year, and adjust portfolios as necessary to reflect the market environment. Stay tuned.