As more and more economists adjust forecasts for 2019 and point to rapid deceleration, we believe the correction may be near its final phase. Assuming U.S. growth slows to a level below 2% by the second half of 2019, favorable interest rate and currency trends will stabilize or even improve corporate earnings. We in the early days of an economic slowdown and not a recession presuming there is no further meaningful escalation of trade wars.
Stocks fell again on Friday as equities lost 4-5% in value last week. Investors are increasingly concerned with forward looking growth in the U.S., as they should be. We have been highlighting not only the pending slower pace of growth into 2019, but the impact, in the first half of next year, from the falling dollar. On top of this news, the big additional factor has been a sharp drop in oil prices over the past month. While President Trump has been pushing for lower oil prices, the sharpness of the decline has rattled investors and added uncertainty to the marketplace. With housing, autos and semiconductors in decline, the addition of another declining sector certainly weakens the economic outlook further.
With all that said, there are still few signs that we are headed for a recession. Consumer demand remains strong, productivity has been increasing slowly, inflation is contained and the number of workers is at record levels. But it is becoming increasingly clear that the energy provided to our economy from tax cuts and expanded fiscal spending don’t seem to be enduring. The threats and imposition of tariffs meant to provide more balanced trading relationships between the United States and our key trading partners so far has borne little fruit. Investment spending grew well under a 1% annual rate in the third quarter and the sharp decline in oil prices almost certainly means capital spending in the oil sector, a key market for investment spending will begin to decline very soon. Watch closely the change in rig count published weekly. They declined two weeks ago. One week isn’t a trend but all trends have to start somewhere. While the U.S. government may be tempted to expand fiscal spending further to support economic growth, the rapid increase in annual deficits, that will continue for several years barring efforts to rein in entitlements, probably limits what can be done responsibly.
President Trump looks at financial markets as a barometer to measure his economic performance. While he denied, via Twitter, that he was dissatisfied with Treasury Secretary Steven Mnuchin’s performance, he appears set to make him a scapegoat for the market’s decline. Perhaps his dissatisfaction with the weak stock market will impact how he approaches the G-20 meeting later this week. One doesn’t have to be a rocket scientist to know that any belligerent statement regarding possible future tariffs, particularly against China, will push stocks down further. While he will waive that stick (Mr. Trump seems averse to using carrots), he has been trying hard to make nice to China in recent weeks suggesting that, at a minimum, he will give the Chinese some slack to begin negotiations rather than bludgeon them further with more tariffs. But when two strongmen like Trump and Xi get together and at least one (and maybe both) look at the world in an “I win, you lose” vision, plans going in may not match the reaction going out. Thus, while logic suggests some degree of near-term tranquility, at least in relation to trade, nothing is certainty until the meetings are over and everyone returns home.
Besides oil, the other big concern has been the Fed. Fed Chairman, Jerome Powell, will speak a couple more times before the mid-December FOMC meeting. He isn’t likely to tip his hand but he might change his tone. Indeed, other Fed officials have been doing that for him. While odds still strongly favor a quarter point rate increase in the Fed Funds rate in two weeks, the Fed is likely to acknowledge the economic weakness beginning and will state unequivocally that any future increases will be predicated on maintaining economic strength while being mindful of inflation. Two months ago, many economists were forecasting growth in the second half of 2019 of 2.5-3.0%. Now there are some predicting second half growth of less than 1.5%. I suspect, when the smoke clears, numbers will come somewhere in between. If growth deceleration picks up steam, long term interest rates will fall and the dollar will weaken. This assumes no further acceleration of trade wars. The weaker growth will be accompanied by a slower pace of employment growth and decreasing inflationary pressures. If the dollar starts to weaken over the course of the next few months, then earnings in the second half of 2019 could actually accelerate after flattening, or even falling, in the first half of the year.
Finally, let me look back at oil. While global demand may be slowing slightly, the real reason for the sudden drop in oil prices is a surge in supply as U.S. production accelerated and both Saudi Arabia and Russia increased production in front of supposedly pending Iranian sanctions. When President Trump pulled the plug on those sanctions, prices collapsed. They are normally weak in the fall, a combination of weak seasonal demand and refineries going offline for maintenance. Thus, the sharp increase in supply against weak seasonal demand ignited the sharp selloff. Next week OPEC meets and will likely agree to pull back production to levels that existed before Mr. Trump threatened sanctions on Iran. Will that be enough to stop the slide? Most say no but it will certainly help. What is clear today is that the U.S. is the new marginal producer. Unlike Russia and Saudi Arabia, which can turn production on or off on command of its national leaders, production in the U.S. is dictated by supply and demand. If prices fall through the $50s and into the $30s, we will get a repeat of 2015 and 23016 when rig counts fell by almost 80%. The excesses aren’t as great this time around, OPEC will cut its production sooner, and the U.S. might yet impose sanctions of some kind on Iran. But, in the short term, the path of least resistance is still lower although there may be some short-term firming around the OPEC meeting. Note, however, that oil prices have a strong seasonal component and it is rare for prices on Memorial Day to be lower than they were the previous Thanksgiving. Therefore, expect some firming by spring although the weaker pricing environment probably means the rebound both in profits and investment spending within the energy sector will be less than what one would have predicted two months ago.
Markets remain dominated by institutional investors. Many are hedge funds whose performance year ends in a month. Right now, that month matters to many portfolio managers. They want to be where the momentum is. Over $1 trillion has come out of yesterday’s momentum names. What seems to have been working best has been defensive issues from consumer staples to utilities. Now these stocks are overpriced, at least the ones, that have had the most positive momentum. The real winners of 2019 probably lie in between, companies that can continue to grow earnings in a decelerating economy but whose share price hasn’t become swollen by the swing in momentum from super growth to dividend-supported value.
I think it is important to note that the correction we are in has gone a long way to discounting a very tough first half of 2019, one with rapidly decelerating growth in the U.S. combined with very negative currency impact on international earnings. By the second half of next year, however, assuming the predictions of decelerating growth evolve as predicted, the environment should change for the better even if growth is below 2% assuming a more favorable currency and interest rate environment. There is a temptation, as markets reach bottom, to get excessively gloomy. Indeed, that is what makes bottoms. Right now, markets are probing for a bottom. We might even need a cathartic 1-2 day blowoff decline of scary proportions built on a spike in volume. It happens that way more often than not but it isn’t a prerequisite for a bottom. Indeed, we came close to that last week and that could have been the bottom. A rally today wouldn’t prove that but a sustained rally all week might. In any case, I think we are close to the low for this correction. If it hasn’t already happened, I think it will occur between now and mid-December.
Today, Tina Turner is 79.
James M. Meyer, CFA 610-260-2220
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