Until the G-20 meeting at the end of November, stocks could move in a choppy sideways pattern.
Stocks were mixed yesterday, a day after a huge post-election rally and a day during which the Federal Reserve held interest rates steady and offered no further future guidance beyond what it already offered. The post-meeting statement was virtually identical to the September statement except for an acknowledgement that capital spending grew more slowly in the third quarter. Stocks fell around the world overnight and futures point to a lower open this morning.
With the rally this week, stocks have now recovered about half of October’s losses. From here, I expect the going will get a little tougher. Over the next couple of weeks, there aren’t any obvious catalysts to push stocks up further other than seasonal trends. We went into Q3 earnings season with some optimism that strong growth would stop the early October slide. But while the numbers reported generally met or exceeded expectations, forward looking guidance was mixed at best and there were signs worldwide that growth rates were slowing.
Very few market observers see a recession in 2019. Asked, many will offer the notion that a recession is a real possibility for 2020 but recessions don’t just happen out of the blue. The come about because of some economic imbalance. The notion is offered that it will be the Federal Reserve that will create the recession by hiking interest rates too far too fast trying to stop a phantom inflation that doesn’t exist. But that conclusion is based on a set of assumptions that stretches at least my imagination. It presumes that Federal Reserve Chairman Jerome Powell will set, or perhaps more appropriately has set, a path of steady Fed Funds rate increases that will take the rate to something close to 3.5%, a number that would not only slow a robust economy but turn it negative. That assumption presumes that Powell isn’t a pragmatic banker with a long business history but a stubborn ideologue. Of course, that flies in the face of all past reality which suggests that he will be very data dependent.
The Fed’s primary mission is to maintain a stable currency. That means keeping inflation in check. To most Fed observers, that means inflation of about 2%, just about where it is today. To be sure, there are pressures that have to be monitored that could push inflation higher. With a 3.7% unemployment rate and wages rising 3.1% year-over-year, the Fed doesn’t want to relax as inflationary pressures increase. But the most recent wage data actually shows month-over-month increases closer to 2%. Crude oil prices in recent weeks have fallen 20% from their peak and other commodity prices are falling. Productivity, the counterbalance to rising input costs, has started to rise. On its present path, the Fed has been raising rates 25 basis points every quarter. One can’t argue that such a pace has slowed the economy to date. To the extent there has been any slowing, trade tariffs and related uncertainties would appear to be a larger influence. I think the Fed will stay on its present course at least into mid-2019. If there is no measurable change in inflationary pressure, it could skip a quarter and monitor the economy. But if wages are rising at a faster pace, say 3.5-4.0% and growth holds well over 3%, then more increases will be forthcoming. Conversely, if inflation stays tepid and economic growth slips below 3%, one should argue for at least a temporary end to rate increases.
Thus, in reality, there are almost no signs of a recession. Sure, there will be one somewhere in the futures but not to the visible horizon. That doesn’t mean, however, that equity markets are destined to rise indefinitely. Indeed, there are many headwinds we face, some that could disappear soon and others that could pick up steam.
- Tariffs – Perhaps the biggest near term question is whether President Trump will implement more tariffs against China in January. The optimists will say that his bark is often harsher than his bite, that he will back away and let negotiations begin after he meets with President Xi of China at the end of November. But that requires Xi to acknowledge the need to allow a discussion of intellectual property rights. There is little question that under his leadership, China has taken a backward step when it comes to economic fair play. If Xi doesn’t want to meet Trump in the middle, Trump won’t hesitate to take a tougher stance.
- Slower growth – We may not see a recession near at hand but we don’t see 4% growth sustained either. Furthermore, growth in Europe and China are slowing. Europe has to deal with a central bank likely to be less accommodating, the conclusion of Brexit, and uncertainty in Italy. China’s debt burden is beginning to look like a house of cards. Slower growth often brings with it inventory liquidation.
- Dollar strength – Although our economy is slowing, it will still grow faster than economies in most other developed nations. We also will have higher interest rates. While I am not a particularly good forecaster of currency, faster growth and higher rates are the key ingredients to a stronger currency. Even if the dollar merely holds where it is today, the year-over-year strength in the dollar will cause a decline of as much as 10% in foreign earnings of U.S. companies expressed in dollar terms during the first half of 2019.
- Decelerating earnings growth – While the impact of the tax cuts are already factored into stock prices, the above factors may not be totally discounted. Standard forecasts still predict earnings growth of close to 10% next year. About 2% of that comes from share repurchases. But if our economy grows at a nominal rate (before taking inflation into account) of 5% and the dollar weighs on international earnings, the only way to get to 8% growth before the impact of share repurchases is for profit margins to rise. That seems a stretch in a decelerating economy. I think a number closer to 2-3% is likely.
Putting all this together, it would appear fair value for stocks is pretty close to today’s prices. If we are around fair value, then the risk of a 10% decline or a 10% rise is about the same. Said in a different way, should the market rise toward 3000 on the S&P 500 by year end, as some predict, I would suggest taking some profits. If stocks reverse and resume their correction, I would be a buyer on the dip. Right now, especially after a very strong last two weeks, I would probably sit on my hands and do nothing. Over the next few weeks, I would expect some backing and filling distilling both the effects of the October correction and the sharp snapback of the last week. Key near term events to watch are the G-20 meeting at the end of November and coming inflation data. Retailers will be reporting third quarter earnings but they aren’t all that important. Q4 is the key and managments at this point in time can only speculate. How do they know what I am going to buy for Christmas if I don’t know myself?
Today, former Eagle quarterback Sam Bradford is 31. David Muir is 45.
James M. Meyer, CFA 610-260-2220
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