This is the time of year to take stock of where the economy and markets stand and try to figure out what lies ahead. Markets are telling us something, and so is the underlying data. In what follows I will try to parse the signals the markets are sending, look at the data and the trends, and give you my view of what 2019 holds for investors.
What the Markets are Saying
Markets tend to be forward looking. The broad declines in equities and the accompanying volatility imply that markets are both confused and worried, and are re-evaluating risk. The flattening yield curve, too, tells us that this isn’t just a “correction” in an overheated equities market, especially since long-term yields have fallen towards rising short-term ones. Markets are concerned about near-term economic growth, which has been decelerating (now noticeably so), and is signaling much slower growth in 2019, and possibly recession. Growth in the rest of the world has soured, another ominous sign for future U.S. GDP growth and for equities.
Wall Street economist David Rosenberg recently made the following observations about market signals:
• The last time the U.S. had a 3.7% unemployment rate was 1969; there was a recession in 1970. We shouldn’t be complacent just because the economy looks strong now;
• The last time the equity and fixed income markets both had negative returns in a calendar year was also 1969;
• Like today, homebuilder and financial equities were both down in tandem in 1990 and in 2007; recessions followed.
Occasionally, markets do send false signals, but their track record is solid enough for investors to pay attention.
Here are my forecasts:
• Economic growth in the U.S. will slow significantly in 2019 with a significant possibility of a recession (perhaps beginning earlier than what the consensus of economists is currently forecasting);
• Recessions will develop in Europe and Japan, and, China’s decelerating growth will continue to be an issue;
• The slower growth from abroad will impact the top line revenue of many large cap publicly traded companies negatively impacting their stock prices;
• In the corporate arena, costs will continue to rise faster than selling prices; putting downward pressure on profit margins and stock prices;
• Corporate CFOs will likely use free cash to pay down debt rather than do stock buybacks or pay dividends, another negative for 2019 equities.
Economic Growth; a Slower 2019
Nowhere is slower growth more apparent than in U.S. housing where rising prices and rising interest rates have had a significant impact on new and existing home sales, on affordability, on permits and new starts, and on mortgage applications.
On the employment side, the biggest complaint of businesses is that they cannot find qualified workers to fill empty positions. That means that growth is hard to come by. A record 25% of the respondents to the November Small Business Optimism Index (National Federation of Independent Businesses (NFIB)), an index dating back to 1973, said that this was their single biggest issue.
And, while the latest reading of the country’s employment pulse, at +155k in net new jobs (November Establishment Survey) would seem to show continued strength, the workweek shrank from 34.5 hours to 34.4, which is equivalent to a loss of 370k jobs. So, on net, there was an equivalent net loss of 215k jobs. The headline U3 unemployment rate stayed at 3.7%, but the broader U6 rate rose to 7.6% from 7.4%. Telling the underlying story was the increase in “part-time for economic reasons” (translated: part-time but wanting full-time) which rose by a large 3.9%.
The economies in the rest of the world are far ahead of the U.S. in their slow-downs. Most equity markets abroad are clearly in bear markets. Approximately 40% of S&P 500 company revenues are based outside the U.S., in economies that are either decelerating or already in recession. Looking around the world, China’s economy has low single-digit growth. Such low growth rates have not been seen since the recession. Both Germany and Japan had negative Q3 GDP growth prints. Italy is clearly in recession, and with ongoing riots, France can’t be far behind. And then there is the Brexit quandary. The revenue implications for large cap U.S. companies is that it will be an uphill fight just to keep the foreign revenue stream at 2018 levels. On top of that, the strong U.S. dollar reduces the translation of revenue collected in foreign currencies to U.S. dollar financial statements. These are really strong headwinds for 2019 equity prices.
The fall in oil prices is certainly a positive for the consumer, likely giving a $40 billion lift to 2019 consumption. If there is anything that will keep the U.S. out of recession, this would be it. But, the positives end there. Restaurant sales, always a leading indicator of consumer health, were down at a 3.6% annual rate in November. Wage and non-wage benefit costs are accelerating. In the NFIB survey, plans to raise compensation was the second highest on record. But the run-up in labor expenses, along with other input costs (freight, items impacted by tariffs, etc.) are not being matched by increases in final prices. In the Fed’s latest Beige Book, the detailed report on conditions in each of the 12 Federal Reserve Districts, there were references to input costs rising faster than the ability to raise selling prices in nearly all districts. This implies that 2019’s profit margins will be squeezed. (In the old days, this was known as “stagflation.”) Thus, the 2019 profit growth forecasts, currently near 9%, are sure to come down as the year progresses.
Many analysts fear that rising rates will cause a new financial crisis, this one in the corporate space. Already yield spreads, the difference between a bond’s yield and its equivalent maturity Treasury counterpart, have widened significantly over the past two months, indicating growing investor concern.
Prior to the recession, BBB credits represented 32% of the corporate bond market. Today, they represent more than 50% with many having balance sheets looking more like “junk” credits (i.e., below BBB-). Already S&P has cut the credit rating of Lowe’s (LOW) from A- to BBB+ because of the company’s “less conservative” financial policy to increase shareholder returns, specifically the company’s $10 billion share buyback program. S&P believes that issuing debt to fund share repurchases will keep the company’s leverage ratio too high.
Over the past few years, Wall Street has rewarded share buybacks and other financial engineering. In the case of buybacks, the reward has been an increase in share prices in proportion to the shares repurchased. For example, a repurchase of half the shares would double the share price. I have argued in prior blogs that the increased leverage (i.e., less cash on the balance sheet) should be a consideration, and the PE ratio should be reduced as a result. Apparently, S&P agrees.
In 2019, corporate CFOs are going to be wary about using their free cash for buybacks and increased dividend payments; instead, using that cash to pay down debt. Buybacks and rising dividends have been a key driver of rising equity prices. There will be less of these in 2019. Just another headwind!
Looking forward, the rate increases already imposed by the Fed along with its shrinking balance sheet has already reduced the level of liquidity, so important for the financial markets. This, along with deteriorating views of the future economic landscape, has caused the yield curve to flatten, which, in turn, has reduced the incentive for banks to lend. That showed up in the Fed’s latest Senior Loan Officer Survey and in a flat line bank loan growth rate. The implication here is that future (2019) growth will slow. The icing on the cake is the fading fiscal stimulus, both from tax cuts and the trillion dollar deficits. These items alone should give investors pause.
Markets are already worried about 2019’s growth, and about recession in the rest of the world. When markets become manic-depressive, as they have over the past couple of months, it is wise for investors to look for safer havens and reduce risk assets. My 2019 forecast is that equities are unlikely to perform well. Bonds, on the other hand, look more promising.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.