Although stocks closed mixed to slightly lower on Friday, last week was a good one for equities.

Last week was the third up week in a row as investor confidence snapped back a bit from December’s sharp downturn.

Now we enter earnings season.  A few high-profile companies that report on off quarters have already guided toward a slower economy.  Others have preannounced weaker than expected results.  Last week, the big department store chains suggested that Q4 profits would miss expectations. While sales were generally OK, more promotional activity was apparently required.  But the woes of the department stores didn’t mean bad times for all.  Leisure and athletic apparel remain hot and the company, which sells primarily through its own stores and distribution channels, has been control of prices and margins than the department stores have selling national brands subject to lots of promotional activity.

Elsewhere, Chinese trade data over the weekend point to a dramatic slowing there.  China is unique among major countries in that government reported data is very circumspect.   Hard numbers, including trade figures, which the government either doesn’t report or can’t be fudged easily suggest that the industrial complex within China is experienced a significant slowdown.  While the consumer doesn’t appear to be impacted as heavily, clearly there must be some echo effect from a slowing infrastructure building.   Futures are off close to 1% in premarket activity representing fear that a Chinese slowdown will spread worldwide.  Both the U.S. and China suggest trade negotiations are going well.  China has already lowered some tariffs and agreed to buy more goods from the U.S.  Given the growing anger over the government shutdown in this country, the Trump administration would love a “win” to regain some popular support.  A deal with China that at least suggests steps to respect intellectual property and the allow greater access to Chinese markets for foreign companies would be such a win.  As we know, even a small step in the right direction will be trumpeted as a victory by both sides.  Markets certainly would like such news.

Stocks have risen about 10% from the Christmas Eve lows.  On a historic basis, assuming growth of 0-5% in earnings per share in 2019, they still remain on the cheap side of average.  That, of course, presumes that profits can stay flat or rise a little bit.  On the plus side, no one is forecasting a recession in the U.S. this year and the outlook for the rest of the world is for slow but positive growth.   Relatively low commodity costs relief one possible price pressure.  Strong cash flows are feeding ongoing stock repurchase programs that, by themselves, might add 2-3% to earnings per share in 2019.  But there are negatives as well.  Decelerating growth suggests some inventory liquidation might be necessary.  We are already seeing that in markets from oil to semiconductors.   Wages are rising at a slowly accelerating pace.   So far, those increases have been offset by improving productivity.  The dollar’s strength in 2018 will be a significant headwind for international earnings through the first two quarters of 2019.  In a few cases, for companies with over 50% of sales overseas, could see negative reported earnings in the first half of the year.   And, of course, there are the unknowns related to policy, notably tariffs.   Add all this together, and it appears that earnings can continue to grow, but significant growth will be a struggle especially early in the year when the year-over-year hit from currency translation is most severe.  

Analysts have been bringing down estimates over the past couple of months.  They certainly aren’t blind to market action and commentary from companies that have recently reported. But history shows that analysts often underestimate the impact of economic change.  In other words, they don’t revise up fast enough as times improve and they don’t revise down fast enough when headwinds start to appear.  I suspect this will the earnings season that will see the sharpest downward revisions.  In fact, if several of the headwinds now facing the market, from tariffs to a strong dollar, subside later in the year, it is quite possible that worries today will force analysts to overcompensate and lower forecasts a bit too far.  Perhaps this is the primary reason that I expect markets to be relatively bumpy early in 2019 and more positive later in the year. 

Beyond the first quarter, my greatest concerns are unforced errors from Washington.  The current government shutdown may foreshadow these concerns.  By itself, the shutdown won’t move the economic needle much although certain companies could see a meaningful short term impact.   We are used to gridlock; we saw it for the last six years of the Obama administration.  But there are significant events still ahead of us that could create obstacles that impact markets.  The debt ceiling will have to be raised.  In the recent past, this has become a political tool that has upset markets.  The fiscal 2020 budget process is another hurdle. The current shutdown relates to a 2019 funding process gone astray over $5 billion in funding for a barrier across our southern border.  We may not have heard the last about tariffs.   In essence, gridlock would be fine as long as Washington does nothing further to upside economic growth.  But as we see almost daily, when it comes to behavior in our capital, the past is no longer much of a guideline for future performance.  If there is any good news from this, I believe now that workers have not gotten paid, law makers on both sides of the aisle will come under increasing pressure to act.  I won’t begin to suggest the compromise other than it will be economically irrelevant per se.  But the distaste that is sure to survive the current shutdown may give both parties and the President food for thought before they try brinksmanship again any time soon. 

Today, LL Cool J is 51.  Faye Dunaway turns 78. Singer Jack Jones is 81.

James M. Meyer, CFA 610-260-2220

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