The U.S. stock market is long overdue for a correction. With rising interest rates, trade wars, slowing housing starts, static auto sales and hacked tech companies, a jolt to the stock market’s complacency is overdue. While these events are unpredictable and nerve-racking, they frequently lead to buying opportunities in the future. September and October are notoriously difficult months for the stock market.
On a positive note, leading indicators and purchasing manager surveys continue to be very constructive and suggest strong GDP growth for the next few quarters. The $1.5 trillion corporate tax cut is just starting to flow into the economy and should create earnings benefits for another year or two. In addition, seasonal flows of funds into the markets turn positive between mid-November and April. Finally, the vitriol from both parties should subside after the mid-term elections and allow the market to focus on economic matters. I expect that overall optimism should return to global equities by year-end and target Dow 30,000 in 2019.
Figure 1 – U.S. Equities Should Find Strong Support at a 10% Correction
Figure 2 – Foreign Equities Have Had a Terrible Year Due to Trade Wars
Foreign Equities Have Underperformed U.S. Equity Markets
The divergence between U.S. and foreign equity performance started in May 2018, about when President Trump imposed a 25 percent tariff on Chinese goods and pulled out of the Iran treaty. The underperformance has continued to widen since then, as he threatened more tariffs on Europe, Japan, Canada, Mexico and China. Emerging markets have been particularly pummeled, as their indexes are heavily weighted with Asian stocks.
Trade issues have been the key impediment to global growth this year. We suspect that growth overseas will reaccelerate as trade deals are reached. Consumer and business confidence will then increase rapidly followed by a sharp acceleration in consumer spending, corporate investment and growth. It has become clear that the U.S. strategy was and still is to negotiate deals with Mexico and Canada first, since our economies are closely aligned and interconnected. Next, the U.S. will work to close deals with Japan and Europe using similar terms to those struck with Mexico and Canada as their template. The Trump team will leave negotiating with China for last, isolating them as much as possible, to enhance our negotiating position at their expense.
Since the successful completion of the deals with Mexico and Canada, their stock markets have been stabilizing on a relative basis. Next up, Europe and Japan.
Figure 3 – U.S. Index of Leading Indicators Remains Bullish
The U.S. Economy is Growing At 3%
Third-quarter real GNP is likely to exceed 3.2 percent, supported by strong consumer demand despite weakness in autos and housing. The trade deficit has continued to expand, penalized by existing and impending tariffs as well as strong domestic demand. Employment data continues to improve and there are signs that wages are rising. Amazon even raised the minimum hourly wage for its employees to $15. This could put pressure on other retailers and restaurants to follow suit. Fourth-quarter real GNP is likely to exceed 3 percent.
All major measures of business sentiment continue to trend higher. The Conference Board’s index of leading indicators is up 6.3 percent year over year. Small business optimism hit an all-time high in August due to tax cuts and deregulation. The ISM manufacturing and non-manufacturing indexes are near record highs. Prospects of continued growth are the leading cause of higher interest rates.
Earnings estimates for Q3 2018 are 19.2 percent greater than in 2017. Energy, financial, material and tech companies are expected to see the biggest increases in earnings growth. Total earnings for the S&P 500 were $133.5 per share in 2017 and projected to be $161.6 in 2018 (+21 percent) and $178 in 2019 (+10 percent). Due to earnings growth the forward P/E of the stock market has declined from 18.3 in 2017 to 16.7 in 2018. Current levels are not unreasonably expensive.
Figure 4 – Interest Rates Have Broken Out to the Upside
Interest Rates Have Broken a 30-year Trend and Turned Higher
Interest rates should continue to trend higher in 2019, but not at a pace that would derail economic growth. Fed Chairman Powell cautioned the markets that rates were far from normalized, but that the Fed will only increase rates gradually, closely monitoring all economic data. We suspect that the Fed will find a time to slow the pace of rate increases in 2019 as the benefits of fiscal stimulus dissipate. We believe the Fed will raise rates this December and 1-3 times next year, depending on the strength of economic growth. It will be interesting to see how the Fed responds to Trump’s tweet bashing.
Inflation has surprisingly only increased from 1.7 percent in 2017 to 2.3 percent in 2018 but is likely to move to the 2.5-3 percent range in 2019. Wage pressures have been growing in the low 3 percent, while commodities (excluding oil) have continued to lag. Housing and rental costs are surprisingly high. Inflationary pressures have been contained due to offsets from global competitiveness, technology, disruptors and rising productivity. Overall, inflation should continue to increase, but not at an alarming rate.
In the last eight years, global monetary authorities (US, Europe, Japan, China) have supplied trillions of dollars through Quantitative Easing to first stabilize and then stimulate global economies, fearing deflation most of all. With global inflation now running more than 2.5 percent, maybe it’s time for central bankers to declare victory, shift toward normalization, promote sustainable growth with low inflation and move forward. Normalized interest rates would be in the 3-5 percent range.
Figure 5 – Federal Deficits Will Soon Reach 5% of GDP
The Budget Deficit is Flashing a Warning Sign
Washington and the public have forgotten that deficits matter. Between 2017 and 2022, the Federal deficit is expected to double from $650 billion to $1.3 trillion, more than 5 percent of GDP. This does not include the hidden costs of government employee pensions or the Social Security internal borrowing account. These should add another $700-800 billion to the borrowing need. It looks like a great time to become a trader of U.S. Treasury bonds and debt.
The government’s cost of borrowing should start to rise quickly. As interest rates rise, the U.S. Treasury replaces 2 percent bonds with 4 percent bonds, then 6 percent bonds. If the economy hits a slow patch, there will be limited room for fiscal stimulus. In addition, the states have tremendous fiscal problems with unfunded pension obligations. Debt issuance will likely become the Achilles heel of the economic recovery.
Seasonal Investment Patterns Favor the Upcoming Winter Months
The monthly pattern of stock market performance (see chart below) has historically favored the winter months with an emphasis on November, December, March and April. More than two-thirds of the annual return comes from these four months. It is hard to be out of the market during this stretch.
Figure 6 – Monthly Seasonality Favors Winter Stock Markets
We found another interesting chart (see below) that describes stock market performance by quarters within a four-year presidential term. It appears that the three quarters during and after the mid-term elections are particularly bullish for stocks. My hypothesis is that the vitriol from both parties should subside after the mid-term elections and allow investors to focus on economic matters.
Figure 7 – Presidential Cycle Favors Post Mid-Term Equity Performance
Investment Themes for Year-End
We believe that growth with low inflation is the real recipe for higher equity values. For now, stock markets can continue to rise as earnings growth should more than offset higher interest rates. The U.S. remains the market of choice for multiple reasons. Overall, we like stocks more than bonds and believe that the benefits of the tax cuts should continue well into next year. While interest rates should increase, it will not be enough to stop economic growth or the markets.
While the markets have been erratic and volatile, we remain fully invested according to our clients’ targeted equity allocations. In fixed income, we have shortened bond maturities and increased bond quality, often by adding short maturity U.S. Treasury bills and notes. We believe that equities should start to rotate from growth and momentum stocks to industrials, financials, energy and small-cap stocks. We believe that equities are the asset class of choice by a wide margin and should rebound into 2019.
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