2019 Macro Economic Outlook and Capital Market Expectations
In the end, the most redemptive image of 2018 was that of a shopper digging into her pockets at the cash register of a box store that only a few years ago had been left for dead.
Looking forward, with markets topsy-turvy, Europe seemingly spent, emerging economies leveled, and China finally succumbing to gravity, we believe the US Consumer will propel the economy deep into 2019. Despite jitters about rising interest rates and a thicket of political risk worldwide, consumers sustained strong spending rates that we believe will continue throughout at least the first half of the year. That places household spending on the positive side of an annual outlook that includes mild inflation, respectable wage growth and job creation, a stable dollar, and judicious tightening of borrowing costs. On the other side of the ledger is the dimming—most likely by the third quarter of this year— of last year’s stimulus policies with nothing in the way of a replacement. The end of synchronized global growth also represents a potential headwind for the year, as does a US Congress occupied by warring tribes, a brittle European Union and Sino-US sniping of unlimited downside. Finally, there is an investing public seemingly unable to reconcile the siren songs of 24-hour news with strong economic fundamentals—a phenomenon we warned of in our mid-year outlook last year.
Given near 3.0% expansion last year, we considered a below-consensus GDP target for 2019. However, having examined the confidence and fitness of the American consumer we forecast the US economy will expand at a healthy 2% plus for the calendar year. As always, and particularly in markets as jumpy as these, the usual disclaimers apply.
THE OUTLOOK FOR 2019
The International Monetary Fund (IMF) in October cut its global economic growth forecasts for 2018 and 2019, noting the toll of the U.S-China trade war and the collateral damage inflicted on emerging markets by tighter liquidity and capital outflows. The IMF cut its 2019 US growth forecast to 2.5% from 2.7% previously, while also cutting China’s 2019 growth forecast to 6.2% from 6.4%. It left 2018 growth forecasts for the two countries unchanged at 2.9% for the United States and 6.6% for China. The IMF’s forecasts were shared by UBS, which announced global growth will slow to an estimated 3.6% in 2019 from a forecast 3.8% in 2018 due to tighter monetary policy, weaker earnings and rising
We anticipate the Fed will raise the Federal Funds rate twice this year, which would leave the benchmark rate about 50 basis points higher by the end of 2019 for a year-end-target of 2.75-to-3.00%. We expect the dollar will average out flat against its major counterparts. We anticipate core inflation will settle at a manageable 2% thanks to relatively cheap commodities such as crude oil, which we forecast will average $60 a barrel for the year. (However, energy-related debt and equity, which suffered last year, may represent attractive points of entry for investors, particularly given looming supply shortages in the 2020s). We expect corporate earnings growth will average in the range of 6% to 8% or greater for 2019, well below last year’s lofty 20%. This is in range of typical output; however, the abrupt drop and expectations of the market could cause some consternation.
Abroad, we agree with the consensus that developed GDP has peaked from 2017 levels and divergent monetary policies may stress foreign exchange and credit markets as the rest of the globe struggles with slower rates of growth. While the Fed continues to reduce its balance sheet, for example, 37% of euro zone and 63% of Japanese government debt still has a negative yield. In addition, hedged yields on US Treasuries are negative for many foreign investors due to rising currency-hedging costs. We do not expect either the European Central Bank or the Bank of Japan to increase interest rates this year.
Meanwhile, soft commodity prices and the global slowdown in general will weigh on emerging markets, which began the New Year still smarting from last year’s currency crisis, but should nurse its way towards 4.25% growth this year. A similar prognosis applies to China, where the economy is expected to slow to 6.0%, its lowest level since 1990 and the dollar-yuan exchange rate should weaken to 7.0. We expect the People’s Bank of China to content itself with indirect ways to stimulate growth rather than resort to overt interest rates cuts. Already, bond yields and spreads for a wide range of borrowers have declined, especially for private firms. Spreads, relative to comparable US rates, have narrowed, helped by renewed expectations that the Fed rate hiking cycle will pause after the most recent increases, implying continued managed weakness for the yuan.
 N/A: Data not available at time of print
*: Wall Street Journal Survey of Economists as of 12/31/2018
**: Estimated 2018 Final Earnings as of 1/11/2019 via FactSet
We anticipate US output to grow by 2% plus in 2019, due largely to the resources and appetites of the US consumer. Historically strong employment rates and rising wages against still-docile inflation will, in our view, power growth for much of the year.
Thanks to record holiday sales, the National Retail Federation reported a volume increase of 4.8% for November and December, for a combined $720 billion compared with the same period last year while MasterCard reported US sales climbed 5.1% during the same two-month period. At the same time, JPMorgan Chase reported in a survey that most small and midsize US businesses have a positive outlook for the domestic economy and expect their businesses to continue growing this year. The survey indicated that 84% of midsize businesses and 74% of small businesses are optimistic about their company performance.
In addition to rising salaries, our research identifies robust disposable income, manageable household debt and promising tax refunds as tonic for a consumption-led economy and a counter-weight to the warning signs that dot the horizon. These include a consensus driven-market structure exposed to small shocks resulting in large negative outcomes, a disconnect between financial markets behavior and “real world” economics, a polarized federal government that promotes gridlock and partisan sniping that fans market volatility and political risk overseas. In addition to these variables, we are also watching two debt-related factors: a sobering accumulation of consumer credit – now at a record-high $3.979 trillion and harnessed largely to finance cars and higher education – and the prospect of a fixed-income crack-up, should demand for US treasuries tumble as the Fed lightens its debt portfolio.
After stabilizing in mid-2018, European economies continued to slow in tandem with USChina trade tensions. Additionally, Germany’s ruling party faced a setback due to local elections, and Italy faced pressure from their populist coalition regarding the potential fiscal policy easing across the region. The European Central Bank is expected to remain accommodative into late 2019 as inflation stays below its 2% target due to significant job market slack in southern Europe.
We believe recession is a real possibility in Europe and is a wildcard that bears close monitoring over the course of 2019. This is further evidenced by Bloomberg, which warned of a contraction in Germany after Berlin announced the third straight decline in factory output in the fall, and investment sentiment in January fell to a 4-year low while posting the fifth straight monthly decline for the category. In France, the Yellow Vest protest continued to disrupt the economy and President Emmanuel Macron proposed a series of nationwide debates to quell the uprising.
Foreshadowing more mayhem to follow, Prime Minister Theresa May’s ‘soft-Brexit’ plans were rejected both by hardliners in her own party as well as EU officials. This leaves the possibility that the UK could exit the EU on April 1, 2019 without an agreement, a key concern among the business community as well as the Bank of England. Although wage and inflation pressures remain elevated due to a tight job market, a ‘no-deal’ Brexit would be a blow to business confidence.
The Chinese economy slowed to 6.5% in the third quarter, its weakest performance since early 2009 and the legacy of an aggressive deleveraging campaign. In response, we expect policymakers to accelerate measures to offset the impact from the escalating trade rift with the US. They include: cutting personal income taxes, subsidizing prices for consumer goods, lowering bank reserve requirements and encouraging local government to fasttrack infrastructure projects. If recent signals from the PBOC and Ministry of Finance are anything to go by, these measures—well-worn from previous stimulative efforts—are likely to be rolled out ahead of the Chinese New Year holidays beginning Feb. 1. Indeed, bond spreads have already reacted positively to anticipations of accommodating credit terms.
In a measure of Japan’s exposure to US-China trade tensions, the volume of exports in September contracted for the first time in nearly two years. The domestic economy is also struggling with the aftermath of recent natural disasters, although a tight job market continues to support domestic consumption and lifts inflation pressures. Premier Abe’s recent party mandate is another positive as it allows him to sustain his fiscal stimulus and economic reform program for at least another three years.
Developing countries, many of which maintain de facto, if not de jure links to the US dollar, have borne the brunt of Fed tightening and we fear they will continue to hobble through 2019 securing their current account balances and foreign exchange reserves— particularly as global growth continues to stall.
According to the Chinese business journal Caixin, almost all emerging Asian currencies are expected to weaken by the end of June, while bond yields are forecasted to rise for countries like Indonesia, India and Thailand. In December, the IHS Markit Manufacturing Purchasing Managers Index (PMI) for China sank to 49.7, falling below the 50 mark that delineates contraction for the first time since May 2017. The slide followed similar results from the Chinese government and extended to Malaysia and Taiwan, where production activity has been shrinking to its slowest pace in years, according to Caixin.
A more cheerful bellwether to watch could be the election in Brazil of the market-friendly presidential candidate Jair Bolsonaro, who has supported much-needed fiscal reforms.
The US China trade “war”—we refer to it as a prize fight, with both bruisers drawing blood—is entering its crucial final months. Having imposed countervailing tariffs worth $200 billion since September, with another $270 billion on the table, Beijing and Washington have until their self-imposed deadline of March 2 to reconcile their differences. We believe a deal is baked into stock prices and that both sides have too much at stake to walk away. The question is whether China will own up to its side of an agreement, or finesse its way around it as Washington preoccupies itself with election-cycle follies. Our money is on the latter.
President Trump’s efforts to withdraw from the Middle East are likely to end nowhere, as interested parties are just as likely to play him as they have his predecessors. Unfortunately, constituent groups opposed to US hegemony in the area—namely Iran, which is waging a regional war in which Washington is a combatant—may push back at a time and place of its choosing, obliging the White House to respond in kind.
With North Korea now a member of the Nuclear Club—though in poor standing—the US faces two options in its intriguing, if not bizarre, relations with the secretive state: let it ride and declare victory, or wage an apocalyptic war for the sake of disarmament. We anticipate the former, though we will allow that these things can take on a life of their own.
The New Year has arrived with a flourish as markets have regained much, if not all the value, they shed less than a month ago. Having resisted the pull of one emotional market lurch, we are not inclined to blindly follow another. Instead, we are focusing on the data points behind the economic and market behavior in a cycle known for throwing elaborate head fakes. If the reward on investment looking forward is not as compelling as it was in the recent past, we are confident the fundamentals are solid enough to make the journey more than worth the ride.
Tactics and Methodology
Each year, the Investment Committee gathers to evaluate the global macroeconomic terrain for the next twelve months and beyond. Amongst the metrics we study are the prospects for global growth, interest rates, corporate earnings, consumption rates, capital formation, selected commodities including oil, and a host of different asset classes.
The process has several distinct parts. Then we develop capital market expectations by blending historic asset-class returns, risk and correlations with a risk premia build-up method, decomposing each asset class into its component risk factors. We then price each risk factor and reconstruct our estimate of fair value returns given the risk factor stack.
Once fair value has been established we survey colleagues and advisers to benchmark our conclusions. In this way, should we find ourselves to be a market outlier we can easily determine if the deviation is justified. It also allows us to anticipate early on which assets are drawing the attention of big investors and whether or not there is an opportunity to capitalize on the allocation trends of others. Finally, we optimize the allocation of a specified risk budget across the global risk factor set.
This year’s Investment Forum was conducted over several weeks and included input from Jeff Rosenberg, CFA, Managing Director and Senior Portfolio Manager at Blackrock, Gary Schlossberg, Senior Economist and member of the Wells’ Capital Investment Policy and Liquidity Management strategy committiees, Dr. Randy Anderson, President and Chief Economist of Griffin Capital, and Stephen Glain, Director of Communications at Anfield Capital and former Wall Street Journal correspondent covering Asia and the Middle East from bureaus in Seoul, Tokyo, and Tel Aviv. Asset classes are comprised of various combinations of risk factors, more easily thought of as the DNA of asset classes.
David Young, CFA®
Chief Investment Officer, IWM, LLC
Brent Pine, CFP®, CPA
President & CEO, IWM, LLC
(480) 663-6000 (p)
(480) 663-6033 (f)
4800 N. Scottsdale Road, Suite 1900
Scottsdale, AZ 85251
*David Young is not affiliated with Geneos Wealth Management, Inc.
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