The Consensus View
Market commentators are attributing the current market sell-off to four factors: 1.) declining global growth, 2.) Fed tightening policy, 3.) a tariff war between the US and China and 4.) high US corporate debt levels. We agree that global growth is slowing and much of this is due to the slowdown in Asia and in particular, the Chinese economy. However, it is precisely this slowdown in China’s economy that could be the impetus for China and the US to come to a trade agreement in the first quarter of 2019. From our perspective, one should not focus on the rhetoric coming from these head-strong leaders, but instead recognize that it is in the interest of both Xi and Trump to come to an arrangement where both sides can claim (a limited) victory, end the trade tariff turmoil and support their respective economies.
The FOMC meets this week and we expect Wednesday’s rate hike will be accompanied by a statement that monetary policy will become data dependent in 2019. As noted in previous reports, the Fed funds rate is 2.25% and headline CPI is 2.2% YOY, which means the Fed’s goal of normalizing interest rates is complete. Moreover, declining crude oil prices should lower inflation in the coming months and eliminate any reason for the Fed to increase rates in the intermediate term. In fact, we would not be surprised if the Fed did not raise rates this week; but we believe one more rate hike is already factored into stock prices and the Fed will move forward on Wednesday. Corporate debt levels have been rising, but as we show on page 3, the 3Q18 corporate debt-to-GDP level of 46.4% is a record high, but not much higher than it has been for several years. More importantly, while the quality of corporate debt may be a potential risk in some portfolios and investors should take precautions, we do not believe corporate debt poses a systemic risk to the financial sector. This is an important distinction. Moreover, if interest rates stabilize at current levels, the risk of corporate defaults is unlikely to increase substantially in 2019.
However, political risk will be a factor in a variety of areas in 2019. As noted in “Our Outlook for 2019” (December 14, 2018) the new Democratic control of the House of Representatives could impact fiscal policy in a number of ways. The tax reform bill is unlikely to be repealed and business regulations are not expected to be reinstated, but tax cuts will probably not be made permanent. We doubt that Congress will be able to pass policy that both sides actually agree on, such as an infrastructure bill, trade, immigration or healthcare reform. Moreover, an aggressive movement to impeach President Trump could weaken the administration, the economy and US confidence. This risk is evident from the most recent small business survey. The sharp decline in NFIB confidence after the election was accompanied by lowered business expectations for hiring and capital expenditures. In short, the midterm elections are apt to have real economic consequences. Meanwhile, political leadership in the UK, France, Germany, Italy and even China are facing domestic pressure as 2018 comes to a close. Individual stocks are not immune to political interference and pressure and this has contributed to weakness seen in Facebook (FB – $143.66), Alphabet (GOOG -$1028.71), Apple Inc. (AAPL – $166.07) and Goldman Sachs (GD – $171.82).
In terms of the 2019 outlook, we have three basic concerns: 1.) the risk that Italy poses to both the European Union and the euro, 2.) the threat sinking US business confidence implies for the US economy and 3.) the absence of a high volume washout in the marketplace.
In our view Italy is a greater threat to the EU than Brexit due to its participation in the euro, the fact that it is the third largest economy in the EU and since its sovereign debt is held by European banks. These factors make Italy’s conflict with Brussels a systemic risk threat that is different from Brexit and larger than Greece was in 2010. But the populist uprising in France by the “yellow vests” that forced President Macron to roll back a gasoline tax, also threatens France’s budget. In our opinion, France’s new budget problem could force the EU to accept Italy’s last budget proposal in order not to appear unbalanced in terms of its demands on various EU members. As a result, we believe the threat Italy could play in the stability of the EU is dissipating.
Tumbling US business confidence is a problem for US economic momentum, and this becomes our number one concern as 2018 comes to a close. There is no quick remedy for this problem, but it is possible that confidence could return in 2019 if Congress agrees on business friendly policy; but until this materializes, we expect the recent highs in the equity market will be a ceiling for stock prices.
High-volume down-days identify an unwinding of leverage and are a sign of a healthy washout in the marketplace; but this has been lacking to date. There have been two days in which 90% or more of the day’s volume was in declining stocks — October 10 and December 4 — and these 90% down days were signals of underlying panic. But to reverse this negative cycle we should see at least one 90% up day. This is still missing and it is a concern. It implies the decline, although dramatic and apt to be short-lived, may still be incomplete.
There are parallels to the current sell-off in the market and the 2015-2016 correction that ended with a 14% drop in both the DJIA and the SPX. This prior correction was triggered by an earnings recession. The 2015 year-over-year decline in earnings produced fears that an economic recession was on the horizon. The current correction is also centered on earnings, but investors are worried about a decelerating growth rate not an actual decline. The 2018 decline has also produced the first oversold condition in our indicators since 2016; but the current oversold reading is less severe. This is sensible since the expected deceleration in earnings in 2019 is also less severe. However, the 2016 decline ended when the SPX’s 12-month trailing and the 12-month forward PE multiples dropped to 19.4 times and 17.6 times, respectively. At this week’s SPX lows similar trailing and forward PE multiples were 16.1 times and 14.7 times, respectively. In short, equities represent far better value today than they did in 2016 and good valuation should support equities near current price levels.
A Confidence Checklist
If business and consumer confidence threatens the US economy, it is important to define what could factors could reverse this confidence slump. We believe there are four things that could materialize in 2019 that could create a confidence rebound. In order of likelihood they are Italy, trade, infrastructure and taxes (ITIT). As previously noted, Italy’s threat to the stability of the EU should fade if Brussels accepts the current Italian budget. We believe they will. A bigger boost to global confidence could appear if China and the US come to a mutual trade agreement. Given the pressures on the global economies, we believe that is also likely. A big third step toward building confidence would emerge if Congress could agree on an infrastructure bill and pass it in 2019. This is less likely in our opinion. A fourth and most impressive factor to boost confidence would be the passage of a bill making the new business and personal tax rates permanent. Not only would this support the real improvement seen in real wage growth in 2018, but it would reinstate the confidence needed for capex and business expansion in 2019. This is not likely in our opinion, but it would certainly generate a re-pricing of equities and lead to a break of the 2018 ceiling.
“Overweight”: Overweight relative to S&P Index weighting
“Neutral”: Neutral relative to S&P Index weighting
“Underweight”: Underweight relative to S&P Index weighting
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