On Thursday, stocks fell by about 2.5%. That sent shockwaves through the market as concerns rose that weakness in China, spurred in part by the tariff wars would set off a worldwide economic downturn.
Then on Friday, the monthly employment report showed gains much higher than expected. Later the same morning Federal Reserve Chairman Jerome Powell said the Board was listening to the angst of the market and was watching data closely for any sign of economic weakness. Suddenly there was a 180-degree mood swing send stocks up over 3% for the day and, as mentioned, a bit over 1% for the weak.
Volatility without directly is emblematic of change. For the past few months, after setting new record highs in the early fall, stocks fell from peak to trough by about 20%. Those who want to be precise can argue whether what we just lived through was a bear market or not but it had all the characteristics of one. Certain well over 50% of the stocks in the S&P 500 fell more than 20% from their highs. Almost 80% were down 10% or more. We have labeled this a valuation correction against an overlay of slowing growth. Friday’s employment report clearly suggests that if the economy is slowing, it isn’t slowing all that much. So much market commentary over the past few months has centered on the Federal Reserve and its policy to tighten monetary policy to withdraw the so-called Fed put, that extra boost provided by low cost money and excess liquidity, and let markets guide the economy without any help or hinderance from central banks. Of course, the U.S. doesn’t work in a vacuum. Central banks all over the world are still largely behaving in an accommodative manner. Thus, if the Fed gets or remains too aggressive in its move toward neutral it runs the risk of helping to push the dollar even higher than it is now. That would dampen demand for exports while reducing the prices of imports and basic commodities serving to slow economic growth and lower inflation. Indeed, over the past few months, that is exactly what has happened.
With that said, Mr. Powell and the Fed have not changed policies. But what they have done, and what proved to be an accelerant to the market on Friday, is that it improved its messaging. The old message, the one the markets didn’t like was that the Fed though it might need to increase short term rates a few more times in 2019 to get to neutral but the timing of such moves would be dependent on the economic data at each FOMC meeting. The new messaging was that data dependence would trump any inclination to raise rates if growth was slowing and inflation contained. Both messages, essentially say the same thing. There is still an argument where neutral is, whether it be close to the current 2.25-2.50% or a bit higher, perhaps closer to 3%. Despite the strong employment report on Friday, virtually everyone agrees that U.S. GDP is slower today than it was in the second quarter when it moved above 4% briefly. But it is still a very healthy 2.5% or better. Forecasts for later in 2019 vary. Some say it may slip below 1.5% while others feel it could stay above 2%. I’m not sure anyone can make a more compelling case for 1.5% or 2.0%. We’ll just have to wait and see. Certainly, the first half of 2018 saw some pent up spending that was waiting for the implementation of the new tax law. That’s now history. And one has to recognize the fear that exists that an economy slowing down may not stabilize until it turns negative. But, as I noted Friday, with consumers spending as much as they are while still being able to save, and gainfully employed, it is hard to see what will frighten them to spend less per capita than they are spending today.
Thus, we are at a crossroads:
- Growth is slowing from 4%+ to something less. We believe 1.5-2.5% is sustainable and a reasonable predictive range.
- The short end of the yield curve has flattened. Rates from 30 days to 5 years are all now in the 2.4-2.5% range. But while the yield curve has flattened, it hasn’t inverted. 10-year Treasuries are still above 2.6%.
- The 2.6% 10-year rate is down from 3.25% in late summer. Inflation expectations are down as well. Dollar strength continues to put downward pressure on inflation.
- Forward P/Es for stocks have fallen from 19x in late January to 15 today. That means that stocks were priced about 20% above historic norms at the start of the year and close to or slightly below historic norms today.
- Global growth is slowing but no major country is currently in recession.
- Earnings of U.S. companies, especially multi-nationals will have a hard time beating estimates of 4-7% growth in the first half of the year in large part due to the strength in the dollar.
- While recent signs suggest that China and the U.S. could reach some sort of trade deal or at least a tariff truce by the March deadline, threats of higher tariffs still loom over both countries.
- The Fed is probably transitioning from a policy of raising rates 25 basis points every 3 months while reducing its balance sheet by $50 billion per month, to a slower pace of monetary tightening.
There are other issues like Brexit and the U.S. government shutdown that could cause short term volatility. But Brexit will be solved one way or the other by March and the government will be open soon despite Trump threats to keep it closes for weeks, months or years. By the end of this week, 40 million Americans won’t be receiving food stamps and by the end of January, it will be clear that tax refunds will be deferred should the government remain shut. That simply isn’t going to happen. I have no idea how the stalemate will be broken but it will and this will become one more noise factor in our rear view mirror before long. Indeed, what the market determined on Friday, is that the Fed is now yesterday’s news. Think about it. The Fed isn’t going to raise rates in all likelihood for at least another six months. Depending on market volatility, it could even slow the runoff of its balance sheet; it certainly won’t accelerate it.
The biggest near term hurdle is Q4 earnings season. In all likelihood, the earnings themselves will be pretty much in line or slightly ahead of forecasts. The key will be forward looking guidance. I suspect analysts have been trying to get out in front of this and have lowered 2019 estimates going into the reporting season. But they still might have a way to go. Indeed, it is quite possible that managements and analysts, being as nervous as they are right now, will even overshoot to the downside. Another way of saying this is that after earnings season is over, estimates for 2019 will be down to or even below what they should be barring either a recession that I don’t see or some major external event, such as elevated tariffs, that currently aren’t built into earnings models.
If you add all this together, the confluence of short term events may be the perfect set up for a reasonably good stock market in 2019 after we get through earnings season. The economy is still growing, inflation expectations are low and so are interest rates, and stocks are reasonably valued if not slightly undervalued. Given the starting point, gains in 2019 of 10%+ are achievable.
Today, Jeremy Renner is 48. Nicolas Cage is 55. Katie Couric turns 62.
James M. Meyer, CFA 610-260-2220
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