ECONOMIC OUTLOOK REPORT – 1Q-2019
Dreher Investment Services, Inc.
January 22, 2019
A Quick Review of 4Q-2018 Markets
The stock market erased its 2018 gain and more (S&P 500 index -13.52%), posting one of the worst fourth quarters in history. The S&P 500 index was down as much as -19.31% during the quarter, before rallying to end the year. Volatility was exaggerated throughout the quarter after being subdued since early April. Fixed income markets experienced elevated levels of volatility as well, with the 10-Year U.S. T-Note trading between 3.24%-2.69% during the quarter. In the first two weeks of the new year, it has settled in above 2.70%.
Stocks hit record highs in late September before ultimately being overtaken by negative projections related to: anticipated pull back in corporate earnings, U.S/China trade war, fears about the direction of Fed’s monetary policy and the unresolved government shutdown. On top of the negative headlines, the significant drawdown in the markets was also impacted by technical factors and algorithmic trading.
1Q-2019 Economic Outlook
From a fundamental standpoint, the U.S. economy remains solid, as illustrated below:
- U.S. GDP – The final GDP level for 3Q-18 expanded at a +3.5% rate, down from the 2Q-18 level of +4.2%. Growth in 3Q-18 was led by personal consumption and a rise in inventories. The GDP report did have some hints of disruption from the trade war as net exports weakened. Analyst estimates for 4Q-18 GDP are currently at +2.8%. It is expected that GDP will continue to slow as the impact of the trade war starts to show.
- Employment and Wage Growth – Payrolls not only rose 312,000 in December, but they were also revised up for the prior two months. This increased the monthly average to a healthy 254,000 for the prior 3 months. In a mixed message, the unemployment rate actually rose to 3.9%, in part because household employment growth slowed and participation increased. As labor markets continue to remain tight, employers are still struggling to find qualified employees to fill skilled positions.
- Corporate earnings – In 3Q-18, both profits (+26.0%) and revenues (+8.0%) maintained their strong pace. Margins have risen thanks to corporate tax cuts and persistently low inflation and interest rates. Analyst estimates for 4Q-18 call for +16.5% profit and +7.0% revenue growth. Earnings growth will likely decelerate in 2019 as the impact of the tax cuts fade.
- Inflation – CPI year-over-year retreated from +2.3% to +1.9%, and the core remained at +2.2%. The decline in energy prices since early October was behind the slide in the headline inflation rate. Wage increases have yet to contribute much to overall upward pressure. Unless inflation begins to accelerate, expectations for multiple Fed rate hikes in the new year will likely begin to fade.
Other relevant topics that bear scrutiny:
Crude- Oil prices dropped to a two year low during fourth quarter. OPEC stopped its production restraints a few months ago to compensate for oil that was expected to be taken out of the market as a result of the re-implementation of U. S sanctions against Iran. At the same time U.S. producers ramped up their production. Oil prices have since recovered nearly 22% to start the year. A large part of the recovery stems from news that Saudi Arabia plans to cut production to boost prices. Even so, continuing increases in U.S. production will likely offset any cuts by the Saudis.
The Fed- The Fed implemented another 0.25% hike in December to raise the federal funds target level to 2.50%. This increase fueled the sell-off in the stock market, as many investors thought it was unwarranted. Since then, the Fed has lowered its projection for 2019 rate hikes from three to two with the possibility of one in 2020. The Fed is receiving criticism as investors fear that their continued rate hikes could inevitably accelerate the next recession.
Where the markets ultimately take us this year will depend upon: 1.) further and significant progress on trade, 2.) bipartisan resolution of the government shutdown, 3.) continued economic growth (or contraction) globally and 4.) recognition by investors that the effects of U.S. tax reform are unlikely to boost corporate earnings in 2019 as they did in 2018. We cannot rule out other impacts related to late-year 2020 campaign jockeying and results from the Mueller investigation.
STRATEGIC MARKET OUTLOOK
U.S. equity markets have recovered nearly half of what was lost as of the December 24th low (S&P 500 index -19.73%) to start the new quarter. Equity markets may well continue to experience amplified swings of volatility as many key issues remain unresolved heading into the new year. New equity buying may warrant consideration of somewhat more defensive selection criteria in the coming months coupled with possible reduction(s) in allocation levels.
U.S. fixed income levels remain a focal point, as the short to intermediate-term yields continue to rise. The Fed has remained committed to the process of rate normalization even when it has been highly criticized. The Fed will be tested throughout the year as they navigate through highly sensitive market conditions. As a result, and as has been our practice for some time now, liquidity reinvestment in fixed income securities will continue to reflect rate-sensitive characteristics in the near term with a clear bias toward short duration.