Stocks rose about 1% on Monday with almost all the gains happening in the last 5 minutes.

That volatile end to the session put an exclamation point to a very volatile week. 

This morning futures are down about 1.5% in the early going, partly erasing that last 5-minute surge and partly due to some weak Chinese manufacturing data which, frankly, won’t make any dent in anyone’s 2019 GDP forecast for the United States.  I want to take another look at 2019 starting with what I believe is the consensus view going into the year. Right now, the general opinion is that 2018 ended on a high note.  Christmas retail sales rose about 5%, 3% or so in stores, and 19% online.   Manufacturing activity in the U.S. slowed a bit but is still growing.  Car sales have flattened out and are expected to remain near current levels going into next year.  Investment spending has also flattened in Q4, based on durable goods orders, somewhat disappointing but totally explainable by confusion in Washington.  Housing will start the new year on a low note but demographics and recent declines in mortgage rates offer some hope that when spring selling season begins after the Super Bowl, the surprise could actually be to the upside.   Overseas, the outlook for Europe is barely positive, about in line with long term expectations, and Japan appears likely to slip back into recession thanks to terrible demographic trends that remain in place.  China will grow more slowly and there is some risk that excess capacity, a surge in empty newly built apartments, and an increasing reliance on the use of debt could cause 2019 to be worse than current consensus expectations.  At the same time, a surge in government-back stimulus might support growing consumer demand.

Against this backdrop, a new chapter begins in Washington as Democrats take over control of the House.  That means they now control the agenda.  Nothing happens without House and Senate agreement which means Nancy Pelosi and Mitch McConnell either find common ground or things grind to a halt. The first test will come this week as both sides sit down with President Trump to negotiate the end of a partial government shutdown.  The focal point is Trump’s demand for $5 billion to finance further development of a wall along our Southern border.  The $5 billion is chump change in the whole scheme of things.  To put that number into perspective, added interest expense alone, a result of more borrowing at higher rates, will add well over $100 billion per year to our deficit.   Entitlement increases already mandated by law will add tens of billions of dollars more.  Thus, the $5 billion is the subject of a political fight, not an economic one.

It won’t be the last battle either.   Expanding deficits are going to become a growing concern.  In 2019, Congress will be forced to increase the debt ceiling.  A little over five years ago, the Tea Party (now represented by the Freedom Caucus of conservative House Republicans) almost created a default situation and did precipitate a move to lower the debt rating on U.S. bonds by Standard and Poor’s.  Thus, the current fight is a small skirmish no matter how you look at it.  Yes, it is currently being blown out of proportion by the media, common practice today.  But its resolution will be looked at as a harbinger of what lies ahead.  If all the parties can’t solve a $5 billion squabble without creating chaos, what is going to happen down the road when a real problem arises?  Thus, in theory, markets shouldn’t pay any attention to a $5 billion fight.  But it takes on more meaning, and therefore affects markets more, when it becomes a roadmap for future fights.

Let me take this a step further.  Republicans (and President Trump) want more border security, tougher immigration standards, increased military spending, and modest spending savings across other discretionary parts of the budget.   The President has shown no inclination to deal with the expansion of entitlements except for some very small modifications around the edges (e.g. food stamp eligibility). The net is that, despite stated desires for fiscal conservatism, Republicans want to spend more mixed in with a few high profile efforts to save to emphasize a false fiscal conservatism.  Democrats, meanwhile, will focus on trying to reinvigorate ObamaCare in some way, expanding coverage to more Americans. They also want infrastructure spending to increase although, to date, they have shown evidence how they would pay for that.  Entitlements are also off the table for Democrats.  Add the interest and entitlement spending increases and the risks rise that Federal spending will get even more out of control in 2019, a risk I am not sure has been considered properly by markets quite yet.

If you put the desires of both parties and the President together, you find very little common ground.  Yes, there will be some small deal making along the lines of “you give me a little and I will give you a little back”. But without some demonstrated way to pay for new programs, what gets passed will be little or none.  That means debt and deficits will surprise to the upside. That is expansionary in the short term at least until the debt service burden becomes overwhelming.

I don’t think, however, that happens in 2019.  Few argue that growth will slow in 2019 from a 3%+ rate in 2018.  Optimists hope that 2.5%+ can be sustained but that appears difficult with flat auto sales, a slight decline in housing, and only modest increases in investment spending.  But, at the same time, it is hard to get too pessimistic.  Housing was down in 2018 and could actually recover a bit this year, a combination of good demographics (household formation growth is strong) and lower mortgage rates.  Consumers continue to both spend at healthy levels and save, a great combination.  While employment growth will likely fall from the 175,000-200,000 pace of 2018, growth can fall to 100,000-125,000 and still allow the unemployment rate to fall.  It would also allow productivity to rise keeping growth above 2%.

Corporate profits should grow again in 2018 but at a more normal mid-single digit pace, in line with the growth in nominal GDP.  Stock buybacks will help earnings per share to grow faster but the strong dollar will be a headwind for multi-nationals.  The net result should be a modest increase in reported eps for the year with most of the growth coming in the back half of the year when currency headwinds subside.   As for interest rates, the 10-year Treasury spent virtually all of 2018 in a 2.50-3.25% range.  With inflation still comfortably below 2%, I think that range will still be in effect in 2019 suggesting normalized P/Es of 15x trailing earnings and 15.5-16.0x forward earnings should be there center point for stock prices. Hence my 2850-2900 target range for the S&P 500.  Given that the 2018 Q4 correction has put us below fair value to start the year, I would expect equities to gain 10%+ by year end although still failing to regain September 2018 record highs. 

Of course, there are always wild cards.  Some are unpredictable and others I could list, like war, are red herring risks that always exist but appear highly unlikely.

With that said, here are some that are real.

  1. Tariffs/Trade – Markets can quickly absorb a U.S. effort to expand existing tariffs on Chinese imports to 25% but markets have not factored in any impact of either going higher than 25% or expanding the tariffs to all Chinese imports.   Tariffs on imported European cars would probably have very modest impact on U.S. GDP but would be meaningful to nations like Germany. 
  2. A debt ceiling debate that gets out of control  – We have seen this happen before and, therefore, it is a risk worth mentioning.  It is important to note that no one, the President, Republicans or Democrats, win if such a debate creates market chaos.  All sides would lose big time.
  3. Who will be the Democratic nominee? –  We won’t know that answer in 2019 but the key players probably will be identified.  The big question is whether Democrats move left, as they often do during the primaries, and lean toward a charismatic progressive or whether any middle of the road candidate that has appeal to the political center can emerge.  As the House races in the mid-term elections showed, Mr. Trump’s appeal beyond his base is limited.  But if Democrats select a very progressive candidate replete with lots of spending ideas and higher taxes, Mr. Trump, or whoever runs as a Republican, will look a lot more appealing to the center.  As all elections show, Americans tend to vote with their wallets.  While Mr. Trump stirs the pot a lot and angers many, equity investors like the mix of lower taxes and less regulation.  Any serious fears that corporate taxes will return to 35% won’t sit well with Wall Street.
  4. Donald Trump – While I don’t expect anything beyond tariffs will have a measurable economic impact, his habit of starting with extreme requests and then walking back toward a compromise always offers the threat of short term volatility.   The other obvious Trump related issue that can’t be ignored is the Mueller investigation.  It is highly likely that Mr. Mueller will issue a report this year which may or may not be a final report.  That could set into motion a whole range of possible outcomes beyond the scope of this letter.  Mr. Trump is also likely to replace key departed personnel, like James Mattis and John Kelly, with people less likely to challenge Mr. Trump’s wishes.  He cherishes loyalty above all else and wants to surround himself with as many of his own acolytes as he can.  Certainly, some decisions, like the abrupt desire to recall all troops from Syria, can still be challenged and cause modest change.   Because most important economic decisions require Congressional action, equity investors should be less threatened.  But they aren’t immune.  For instance, Mr. Trump has threatened to seal the southern border if he doesn’t get his wall funding.  I am not sure that could be done but, clearly, he can affect some short term chaos.

If we add all this together, 2019 is actually shaping up to be a pretty decent year and maybe even a better than decent year for stocks. Given the heightened volatility in recent weeks and the need for some further earnings adjustments, which should happen after Q4 results come in beginning in a couple of weeks, 2019 may get off to a somewhat rocky start. But unlike 2018, when valuations were stretched as the year started, this year valuations are relatively cheap.  Assuming no recession, nothing matters more than valuation.  As we get passed the first few months, when Brexit is resolved one way or the other, tariff concerns become less fuzzy, and we all get to see whether Trump and Pelosi can find any common ground at all, clouds should give way to some sunshine.

Today, Kate Bosworth is 35.  Cuba Gooding, Jr. turns 50.

James M. Meyer, CFA 610-260-2220

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