End of the Year Complications

Now that the mid-term elections are behind us, we’ve gained some clarity on the current market movers. There are two major things to watch closely over the near term:

1.The Fed. There has been considerable discussion in recent days about interest rates in 2019. Chairman Jerome Powell clawed back comments from October while simultaneously taking a beating on policy from the president. The market initially responded positively, and then pulled back. Chairman Powell is trying to find his footing at a tough time. The central banker is trying to avoid the mistakes of the past (i.e. being too passive and running the risk of an inflation spike) while being called a “threat” by President Trump. Trump has said he is “not at all pleased” with the Fed’s efforts, which run counter to the president’s expansionary agenda.

2.China trade. Last week’s G-20 meeting in Argentina didn’t provide an immediate long-term solution for this ongoing global bugaboo, but it did create some breathing room for US and Chinese negotiators. If substantive progress is made over the 90-day negotiating period, it will serve to lift some of the uncertainty that is holding back companies from committing capital and making other business investments.

Where are we as we enter December? It appears very likely that we will see a hike at the meeting this month as expected. But now the three hikes that were penciled in for 2019 are in doubt. At the Economic Club o f New York speech Powell spoke of having a greater level of flexibility in reacting to the data going forward. He likens the current situation to walking into a dark room filled with furniture. “What do you do? You slow down. You maybe go a little less quickly. You feel your way. Under uncertainty of this kind, you be careful.”

As far as the US’s relationship with China goes on tariffs, China seems likely to come to the table with a real attempt to ease tension with Washington. Their economy and markets have been hit hard by trade developments this year. The US is also feeling pressure to make a deal. White House economic advisor Larry Kudlow thinks something will happen quickly. We don’t need a fundamental restructuring of this relationship to soothe investor fears. What are needed are enough reasonable gains on trade balance and unfair practices to provide the Trump administration with cover on this important issue.

The US economic picture is generally pretty good, despite all of the recent talk of the yield curve and recession. At this point, we should remind everyone that the average lead time between a yield curve inversion and the recession (if it follows, and it doesn’t always) is more than 26 months. The second reading on 3rd Quarter GDP came in with no change, still at a solid 3.5%. The 4th Quarter GDP Now estimate from the Atlanta Fed is 2.8%. There are some soft pockets, housing and energy come to mind, that are becoming a drag on growth. But the all important consumer remains strong, with October retail sales bouncing back and a surge on Black Friday/Cyber Monday. Confidence remains high.

We expect GDP to slow to around 2.5% in 2019, but we see no recession on the immediate horizon. Corporate earnings growth will be slower due to the higher base (after a blistering 20.4% growth rate in 2018). FACTSET pegs 2019 profits growth at 8.8%, which is good enough to drive moderate equity price gains.

As always, there are some geo-political risks to global growth. With oil prices dipping below $50 for the first time in more than a year, Saudi Arabia and OPEC are trying to dance on the head of a pin. Disruption in the Middle East (don’t forget Iran) is a low probability, but with high associated risk. Brexit continues to be a mess, with Prime Minister May clinging to a razor-thin support margin as she tries to steer Britain toward a deal with the European Union. Legal challenges loom. It is estimated that there will be a $10 billion loss to the UK economy over the next 10 years as a result of Brexit. Also, the Italian debt crisis brings the risk of contagion.

While any of these items could become a bigger story, we don’t see extraordinary overseas risk at this time.

In the past we have discussed the two biggest risks to US equity prices: interest rates and an economic bubble. Both of these risks seem to be contained at this time. Also, as we’ve previously mentioned we are entering a period of upside bias for equities, both seasonal (end of quarter and January) and historical (post-midterm and post-decline in emerging markets). Our broad-based international and emerging markets fund have already shown a good bounce in November.