Storm clouds remain and investors continue to be nervous.

But the skies should gradually clear next year if trade wars don’t intensify.  

Stocks continued to rally on Friday but the rally wasn’t wide spread and it faded in the end.  Barring any sudden positive news, one should expect a choppy market this holiday week in advance of the G-20 summit next weekend at which time Presidents Trump and Xi are scheduled to meet and, hopefully, set the stage for trade negotiations.  But both are headstrong leaders and either, upset at not getting their way, could back out setting the stage for a destructive trade war.  Wall Street is still betting that some accommodation, which may simply mean the deferral of trade hostilities, will happen. Xi doesn’t need to help slow Chinese growth further while Trump, who looks at the stock market as a scorecard for his economic program, doesn’t want to see another sharp drop toward bear market levels.

With that said, Wall Street remains nervous.

  1. Corporate eruptions have bond investors on edge. Credit spreads have begun to widen and risks are clearly rising even as the economy continues on a 3% growth pace.
  2. Trade frictions will remain elevated at least until the G-20 meeting.
  3. Oil prices have dropped sharply as Trump hoodwinked the Saudis into expanding production as we was making deals to ease possible sanctions on Iranian oil. Now the Saudis promise to go to the December 6 OPEC meeting and push for a production cut.  Our relations with China, Iran, Saudi Arabia and Europe continue to deteriorate.  That may not prove harmful economically but it certainly won’t be good.
  4. The Federal Reserve is likely to increase short term interest rates on December 13 unless the unemployment rate jumps with the November employment report or some other economic indicators show a sharp deceleration in our economy between now and then. That is unlikely. While we expect the Fed to acknowledge some slowdown in growth at the meeting, traders will remain nervous that future rate cuts may force economic growth to decline more than expected.
  5. The strong dollar almost guarantees international revenues and earnings, expressed in dollars, will decline in the first half of 2019.

So what’s the good news?  Actually, there is quite a bit.

  1. There is no significant reason to expect an economic slowdown to morph into a recession. Employment and productivity are still growing. Confidence remains high. While the short term lifts of corporate tax hikes and expansionary fiscal spending elevated growth from 2% to 4%, as those forces recede, the logical expectation is that growth returns to 2% or a bit better, not zero.
  2. Less growth reduces inflationary pressures. If productivity can grow 1.5% or so, input costs, including wages, can grow 3.5% and still leave inflation close to the Fed’s 2% target.
  3. The dollar won’t rise indefinitely. We expect maximum year-over-year strength to begin to dwindle in the second half of 2019.
  4. Trade wars are destructive and won’t continue indefinitely. It is entirely possible that trade war fears are at a peak right now.
  5. Despite worries that the Fed will move rates up too far, too fast, without inflation data to support a quarter point rate increase each quarter, we would expect the pace of rate increases to slow in 2019.

As we have noted often over the past two weeks, we believe current prices are close to fair value which suggests stock prices should rise gradually with rising earnings over the next year or more.  While reported earnings may be flat in the first half of 2019 if the dollar remains strong, companies who primarily do business in the U.S. will continue to grow.  Beyond midyear, corporate earnings growth should spread to most companies.  If stocks look 60-9 months ahead, markets today should be anticipating the worst, i.e. a slowdown in growth and flattening corporate profits in the first half of 2019.  But as the clouds clear and markets start to look further out, the bull market will resume and stocks could move higher.  If there are no new tariffs in early 2019 and the Fed can convince markets any future rate increases in 2019 will be data dependent, we believe a nice year end rally could ensue.

Today, Ryan Howard is 39.   Jodie Foster is 56.  Meg Ryan is 57.  Allison Janney turns 59.  Larry King is 85.

 

James M. Meyer, CFA 610-260-2220

 

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