“The pessimist complains about the wind, the optimist expects it to change; the realist adjusts the sails.”
William Arthur Ward
“Slow steaming” is a term used in the shipping industry when a ship slows its speed to conserve energy. To adjust its course, a ship can always rely on fuel reserves to reach its next port. Similarly, the Fed continues to conserve its energy by raising rates, while economic growth is strong, to prepare for the next economic slowdown when rate cuts may be required. Tax cuts continue to have an outsized impact on U.S. growth, which is expected to slowly diminish perhaps at the hand of tariffs. In this post-election edition of Market Monthly we focus on a steady but slowing growth trajectory for the U.S. economy in 2019 with the distraction of the midterms now behind us.
Implications from the Midterms:
Our focus remains only on economic implications from the election outcome and not the outcome itself. An energized voter turnout of 114 million voters (vs. 83 million in 2014) delivered a split Congress, allowing each party to claim partial victory – with Democrats winning control of the House and Republicans expanding their Senate majority.
The election results are likely to have a minimal impact on the market. Markets had begun to assign equal shares of event risk (volatility) if either party swept both chambers. Concerns about a rollback of recent tax cuts in the event of a Democratic sweep were balanced by concerns about an expanding budget deficit due to more potential tax cuts by a Republican sweep. In the end, the economy and financial markets are much bigger than Washington would like to admit but a split Congress may turn out to be the least volatile market outcome.
Months Ahead for Washington:
- The G20 meeting scheduled between Presidents Trump and Xi of China will likely result in better optics with little substance and no outcome.
- Tariffs of 10% on Chinese imports are on track to be raised to 25% at year-end.
- USMCA (formerly NAFTA) is to be signed late in November with an early 2019 vote.
- We will have a lame duck Congress for the balance of 2018 with few market-relevant issues.
- A government-spending package is crucial but likely to be delayed until 2019.
- The special election for U.S. Senate in Mississippi will be held on Nov. 27 since no candidate garnered 50% of the vote.
- No meaningful trend emerged from this election to move the market needle by itself.
- An uneventful Washington agenda should have limited market impact for the balance of 2018.
- The Mueller probe remains a risk event outlier.
- Tax policy, infrastructure, health care and 2020 candidate announcements top the early 2019 Washington agenda.
- Trade, debt ceiling, Fed and GDP growth trends top the 2019 list of relevant economic highlights.
Peak Levels or Peak Growth?
The October correction was the market’s response to the idea of a “growth scare,” which was further fueled by aggressive Fed language. In the end, we saw our second 10%+ correction for 2018 for the S&P 500. This is normal market behavior investors should come to expect.
The chart below illustrates the path of the Fed Funds rate since 2008. In December it will have taken three years for the Fed funds rate to move from 0% to 2.5%. This glacial pace of rate hikes in such a low rate environment is the reason economic growth has not flinched. Interest rates are just now starting to catch investors’ attention with modest slowdowns in the housing and auto industry. Markets are anticipating the Fed will slowly sprint toward a “normal” Fed funds rate of 3% by next June. We anticipate GDP growth to slow but do not think the GDP levels have peaked. We see no imminent recession threats.
The chart below illustrates the expected impact to U.S. GDP growth from last year’s tax cuts and increased government spending. Above the “zero” line reflects that these two items are additive to growth. There are two primary trends:
- Q3 and Q4 2018 as well as Q1 in 2019 are expected to represent “peak impact” adding roughly 1% to GDP from fiscal stimulus.
- These two sources are expected to continue adding to growth “levels” but at declining growth rates through mid-2020.
In our December 2017 edition of Market Monthly we said:
“In 2018 the key will be striking the right balance between tighter Fed policy and easier fiscal policy. The simultaneous execution of these contrasting policies must be delicate so further rate hikes don’t diminish the anticipated economic impact of tax reform. It will be one of the most important stories of 2018.”
Fast forward to today and we have watched this “balancing act” between Fed and fiscal policy play out in real time to near perfection. In short, Fed and fiscal policy have pulled the oars of the rowboat in the same direction at the same time charting a somewhat straight path. In 2019 the path is likely to be forward but less straight.
Takeaways for 2019 Growth Trends:
- Consumers and corporations alike remain healthy.
- Recent economic data has become more mixed but is not yet at an inflection point.
- Fed policy is getting tighter but is not yet restrictive.
- Fiscal policy is expected to add 1.1% to Q1 2019 GDP growth declining to .5% by Q4 2019.
- Tariff uncertainty is contributing to tighter financial conditions.
- GDP growth is expected to slow from its Q2 pace of 4.2% to a 2-2.5% rate by late 2019.
- We have not yet seen peak GDP but have likely seen peak GDP growth for this cycle.
- Recession risks are benign with no indicators flashing caution.
Q3 earnings calls have revealed that corporate management is closely monitoring three primary sources of potential pressure for today’s record high profit margins.
Wage Pressures: A recent survey revealed quality and quantity of labor are being cited as the single biggest challenge small businesses face today. The lowest unemployment rate in 50 years has recently nudged wage inflation above 3% for the first time in several years. Historically, when the unemployment rate and average hourly earnings growth both converge at 4%, recessions generally follow. We’re not there yet but are watching closely.
Debt Service Costs: Corporate debt levels have risen appreciably since 2008. Rising interest costs and limitations on the deductibility of interest expense from the Tax Cuts and Jobs Act have positioned this as a risk to profit margins especially for smaller and lower quality companies that have not paid down debt from repatriated overseas cash.
Tariffs: According to FactSet, 2019, S&P 500 estimated earnings are expected to grow from roughly $162 to $178. It has been estimated that tariffs could cost $5-$7 per share in S&P 500 earnings in 2019, which could shrink earnings growth from 9% to 5%. The ripple effects from a tariff-induced slowdown in business spending remains a more primary macroeconomic risk.
October Correction Needs Repair:
The October correction has enjoyed a post-election bounce as of this writing on Nov. 8, but it is still too early to call the all-clear sign. Under the headline index results lies a sloppy U.S. market that lacks conviction buying volume. S&P 500 earnings have once again grown at a rate of more than 25%, but companies beating expectations have not been rewarded whereas those who have missed expectations have been punished.
The chart below shows despite an S&P 500 YTD return of over 5%, almost 60% of the stocks in the index have declined by over 10% and over 30% have declined by over 20% from their 52-week high. Continued positive economic data supported by convincing buying volume is needed to return the broader index to health.
This year has given us two 10% corrections but the calendar has historically been kind to S&P 500 Q4 returns, especially during a midterm election year generating an 8.7% return since 1946. Expectations cannot be built by applying historical returns to current conditions and expect the same result but the trend is relevant. The U.S. continues to outpace the rest of the world with large cap growth companies leading the way. International markets remain stuck somewhere between a correction (Europe down 10%) and a bear market (China down 20%).
Though the chart below reflects performance through the end of October it should be noted most U.S. markets have bounced back into positive territory for the year since Oct. 31, 2018.
The typical risk-on/risk-off trade we have seen since 2008-2009 failed during the October correction. Usually, a stock market correction leads to a flow of funds into bonds as investors take risk off the table. Fund flows from stocks into bonds can most easily be seen through lower bond yields however bond yields are actually higher now than they were before the correction. This is for two basic reasons:
- Markets no longer doubt the Fed means what it says when they say they will continue to hike rates.
- Cash yields have improved significantly and are now the “risk-off” asset of choice. Today, investors buying a 1-year T-Note can capture 85% of the income earned in a 10-year T-Note but without the risk.
Finally, the Barclays Global Aggregate Bond Index is one broad measure that attempts to throw a broad net around the investment grade segment of the world’s bond markets. It is notable that since 2001 the two lowest credit quality segments (A and BAA) have grown from less than 10% of the total index value to a combined 43% as of Oct. 31, 2018. An increase in lower quality bond issuers is important to the extent that credit spreads need to be closely watched for signs of deterioration as a leading indicator for future recessions. Credit spreads remain tight, but it is on our radar as an early warning indicator later in the cycle.
Below are the YTD returns for various segments of the bond market.
- The economy has not peaked for this cycle but the growth rates likely have.
- Midterm election results are a modest market positive.
- Presidents Trump and Xi’s November G20 meeting is a positive development.
- Fed hikes are not yet restrictive but risks rise into mid-2019.
- Fiscal policy continues to fuel U.S. growth with a diminishing impact in 2019.
- Tariffs pose a risk of damaging the positive effects of tax reform.
- The recent correction was not unusual but follow-through buying is needed for repair of market health.
- U.S. debt debate is an emerging risk in 2019. (Must avoid a 2011 repeat.)
- The yield curve is likely to flatten modestly into 2019 with limited inversion risk.
- Continued earnings strength at slower growth rates likely to guide stock returns in 2019.
- Slow steam ahead.
Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors
This piece is produced by BB&T’s Wealth Portfolio Management Team.
The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.