Fourth Quarter Market Outlook. Jason Bulinski, CFA Donald A. Powell, CFA Joseph Styrna, CFA

Transcription

1 Fourth Quarter 2018 Market Outlook Jason Bulinski, CFA Donald A. Powell, CFA Joseph Styrna, CFA

2 Economic Outlook Growth: Strong 2018, But Expecting Slowdown in 2019 Growth & Jobs GDP* Q3: 3.4% Q4: 2.6%E (2018=2.9%E) 2.30% 1.50% 2.90% 2.60% 1.70% 2.20% Consumer Spending* Q3: 3.5% Q4: 3.1%E (2018=2.7%E) 2.80% 2.70% 3.60% 2.90% 1.50% 1.50% Unemployment # Dec: 3.9% 4.10% 4.60% 5.0% 5.70% 6.90% 8.60% * Payroll Bureau of Additions Economic Analysis # (next release: Dec: July 312,000 27, 2018) YTD: 2,638,000 2,188,000 2,344,000 2,712,000 3,005,000 2,301,000 2,151,000 # Bureau of Labor Statistics *Bureau of Labor Statistics #Bureau of Economic Analysis (Next Release: January 30, 2019) Data Still Solid - Despite Some Slowing The U.S. economy grew at a pace above-trend for this cycle with expectations to finish 2018 with a growth rate near 3%. If the economy continues to grow through June (which we expect) then it will become the longest expansion in the Post-War Era, surpassing the 120-month cycle from We expect the pace of growth to slow in 2019, as the 2018 numbers were boosted by fiscal stimulus from tax cuts. The peak in growth may have been the second-quarter of 2018, at a pace of 4.2%, followed by a still-strong 3.4% in Q3/2018, with the estimates for Q4/2018 at 2.6%. Consensus estimates (Bloomberg) for GDP in 2019 are for a slowdown to 2.6%, and further slowing in 2020 to 1.9%. The labor market continued to show gains, with monthly gains averaging 220,000/month this year. Unemployment remains low at 3.9% and now has been under the Federal Reserve s estimate (4.5%) of NAIRU (Non- Accelerating Inflation rate of Unemployment) for 21 consecutive months. In mid-december, the Federal Reserve raised rates for the fourth time in 2018 and the ninth time this cycle. At that meeting, the Fed signaled further rate hikes (2) in The Fed intends to hold a press conference after each meeting in 2019 to promote transparency. Inflation is currently close to the Fed s target for price stability around 2% (Core PCE at 1.9%) and expected to decline with the recent drop in commodities. The Consumer Price Index is at a level of 1.9%, excluding food and energy 2.2%. On the next page, notice that the Employment Cost Index (2.8%) is trending higher and is now near decade highs. Overseas growth slowed during the second half of the year. Leading indicators of global growth pointed to slowing, with the OECD Leading Indicators declining for 11 straight months and the JP Morgan Global PMI-Composite showing modest growth, albeit at 27-month lows. Data in China declined with retail sales at 15-year lows, auto sales at 20-year lows, and factory output at 4-year lows. Japan showed contraction (tsunami and earthquake impacted GDP). Germany posted a negative quarter (impacted by environmental changes) and 2 other countries in Europe contracted as well (Italy and Sweden). After near-term challenges, overseas growth should stabilize with China estimated to grow at 6.25% in 2019 and 6% in 2020 and European estimates at 1.6% in 2019 and 1.5% in 2020 (Bloomberg). Market Outlook Fourth Quarter

3 Economic Outlook Core Inflation Remains Stable Inflation Measures Consumer Price Index (CPI) # Dec YOY: 1.9% 2.1% 2.1% 0.7% 0.8% 1.5% 1.7% Producer Price Index (PPI) # Nov YOY: 2.5% 2.5% 1.7% -1.1% 1.6% 1.2% 1.9% Core PCE * Nov YOY: 1.9% 1.5% 1.8% 1.3% 1.9% 1.5% 1.9% Unit Labor Costs # Q3-18 YOY: 0.9% 0.4% 1.1% 1.8% 2.0% 0.9% 1.7% Employment Cost Index # Q3-18 YOY: 2.8% 2.5% 2.2% 2.2% 1.9% 1.9% 1.9% #Bureau of Labor Statistics *St. Louis Federal Reserve With the ongoing economic expansion now at 9.5 years, we will continue to monitor data including any potential late-cycle slowing. Growth can continue based on: Inflation remaining stable. The Fed does not have to aggressively raise rates at this point. Other developed economies also continue to have low unemployment (Germany at record lows and Japan near 2%), with low inflation levels. Labor Market. Jobs reports have remained solid, and consumers remain the largest part of the U.S. economy. Consumer Confidence and Business Confidence enter 2019 at high levels. Both figures are off their peaks but remain near historical highs. For consumers, holiday shopping data was strong; although business spending slowed later in the year. Trade Dialogue. Trade representatives from China and the U.S. are expected to meet in January (potentially twice). The U.S. did delay additional tariffs on Chinese goods from 1/1/19 to 3/1/19. Areas of concern include: Trade War. The on-going trade war leads to greater uncertainty for businesses and consumers. Higher tariffs act as a tax on goods for consumers. For businesses, it leads to difficulty managing their supply chains and potential lower demand for their goods if other countries also raise tariffs. Furthermore, businesses may curtail or delay business investment or capex. Peak activity. At this stage of the cycle, housing activity and auto sales have likely peaked. Homes & autos will continue to be purchased but at a slower pace. Worker shortages. Late-cycle data shows that large and small businesses both list hiring and retaining qualified workers as a problem. This can lead to higher inflation rates down the road. Policy Error by Central Banks. With global growth slowing, there is the potential risk of a policy error by a central bank (including the Fed). Raising rates into an environment where growth is slowing or stalling can choke off potential growth leading to recession. Debt Levels. Corporate debt levels are at record highs in terms of absolute levels and relative to GDP. Higher interest rates lead to higher debt-service costs and lower profitability. Yield Curve Inversion. Thus far, the yield curve has flattened but not yet inverted. The spread between the Ten-Year Treasury Note relative to either the Two-Year Note or the 90-Day Treasury Bill is still positive. Slower Global Growth. If growth outside the U.S. slows worse than expected, it can negatively impact the U.S. data. Since 2009, the U.S. economy was able to withstand prior global growth slowdowns in 2011 (Euro-Crises) and 2016 (China slowdown). Market Outlook Fourth Quarter

4 Stock Market Market Slide: Sell, Ask Questions Later. Source: FactSet 4th Qtr Market Outlook Fourth Quarter DJIA % -3.48% 28.1% 16.5% 0.2% 10.1% 29.7% 10.2% 8.4% 14.1% S&P % -4.38% 21.8% 12.0% 1.4% 13.7% 32.4% 16.0% 2.1% 15.1% Russell Mid Cap % -9.06% 18.5% 20.7% -2.2% 12.3% 33.5% 17.9% -1.7% 26.6% Russell 2000 (Small) % % 14.6% 21.3% -4.4% 4.9% 38.8% 16.3% -4.2% 26.9% NASDAQ % -3.88% 29.7% 7.5% 7.1% 13.4% 38.3% 15.9% -1.8% 18.2% Internat l (Developed) % % 25.0% 1.0% -0.8% -4.9% 22.8% 17.3% -12.1% 7.8% Emerging Markets -7.48% % 37.3% 11.2% -14.9% -2.2% -2.6% 18.2% -18.4% 18.9% Bloomberg The depth and speed of the market downturn forced all investors to re-examine both the conditions of global economy and U.S. economy. Had you asked the question earlier in the year, was a future U.S. recession near and imminent. You would not have thought deeply about all the responses, evidence, or how low the probability of a U.S. recession would be with the support for future U.S. growth. Markets did seem to suggest near the end of the quarter that a recession was in the cards sometime in the next 12 months. The fear in the market was extreme, even irrational at times as seen in the increasing levels of the implied volatility of the market, drop in intermediate and long-term treasury yields, and rise in gold. Peak corporate earnings growth only became a larger issue during the quarter as we saw indications of U.S. growth slowing that started out in the cyclical sectors including housing and semiconductors. We had 3 sequential earnings quarters with growth at 25% or higher for Estimates for Q4 continued to decline all quarter with the estimate at 10.6%, down from 16.7% September end. For Q4, 7 sectors in the S&P 500 Index have lower growth rates compared to the beginning of the quarter with 72 issuing negative EPS guidance and 34 issuing positive EPS guidance. China has been cited as a large negative impact on recent conference calls. International equities declined less during the quarter only due to the fact that non-u.s. equities started to sell off earlier in the year when markets saw slowing growth in China, Japan, and Europe. The forward 12-month P/E ratio for the S&P 500 is 15.1x, below the 5-year average 16.4 but above the 10-year average Looking ahead, based on the jobs data and recent shift in sentiment from the Fed, recession fears seem premature. For 2019, analysts are projecting earnings growth of 6.9 and looking out to 2020, growth of 11%. There are no apparent signs of the economic imbalances that started the 2008 meltdown, beginning in housing that moved into the banking sector. Shown below are earnings growth estimates for the S&P 500. Qtr 1 Qtr 2 Qtr 3 Qtr 4 Year S&P 500 Operating Earnings Growth % 10.5% 6.6% 15.0% 11.0% % 25.0% 19.3% 10.6%E 20.1%E % 6.9%E %E 2010

5 Stock Market Outlook: High Volatility Given the Earnings Slowdown, Yield Curve, and Fed Response Looking ahead, stocks should move higher for the following reasons: The decline in commodities will relieve rising inflation levels and give the Fed more latitude to pause with all the questions about the global economy and trade uncertainty. Expectations for continued tightening of monetary policy, a Fed mistake and political paralysis seem high and as such stocks are certainly cheaper after 2018 s dismal performance. It doesn t take much to start shifting sentiment as the reasons to be bearish seem imbalanced based on the earnings yield of the S&P 500 Index. However, stock markets may experience volatility from several potential catalysts. Further political uncertainty, quantitative tightening and Fed policy mistake concerns. A continued global slowdown and continued negative sentiment with unresolved trade talks. Late stage investing as the cycle matures and a trade off between stock and bond valuations gives way. U.S. stocks may outperform their peers over the next 6 months owing to the expectation that real interest rate differentials will continue to influence the dollar. A lower level of growth in Europe, Japan, and emerging markets may prevent other central banks from matching the Federal Reserve s rate path. Market Outlook Fourth Quarter

6 Interest Rates Quarter: Mixed Bloomberg 12/31/18 4th QTR 12/31/18 12/31/17 12/31/16 12/31/15 12/31/14 12/31/13 12/31/12 Bond yields were mixed finishing down in the 4th Quarter. The yields rose from September 28 through October 10th. On November 8th, yields started to go down as the bond market rallied. The 10-year yield was 3.24% and fell to a low on December 31st at 2.69%. The biggest contributing factor was the increased volatility in the equity markets as money poured in to bonds for safety. Corporate bond and High Yield spreads widened during the quarter. Equity market volatility and falling oil prices spilled over to the corporate bond sector making it the worst performing Investment Grade sector. High Yield also suffered as falling oil prices make it harder for smaller oil producers to achieve profitability. Investment grade spreads widened by 47 basis points to 153 on 12/31 from 106 on 9/28. High Yield spreads widened a whopping 210 basis points to 526 on 12/31 from 316 basis points on 9/28. Treasuries, by far, was the best performing sector last quarter. Other Fixed-income returns are posted below: 12/31/11 3 Mos T-Bill 2.36% 0.56% 1.88% 1.38% 0.50% 0.17% 0.04% 0.07% 0.04% 0.01% 6 Mos T-Bill 2.48% 0.61% 1.92% 1.53% 0.61% 0.48% 0.12% 0.09% 0.11% 0.06% 2 Year Treasury 2.49% 1.30% 1.49% 1.88% 1.19% 1.05% 0.67% 0.38% 0.25% 0.24% 5 Year Treasury 2.51% 2.83% 1.47% 2.21% 1.93% 1.76% 1.65% 1.74% 0.72% 0.83% 10 Year Treasury 2.68% 3.86% -0.02% 2.41% 2.44% 2.27% 2.17% 3.03% 1.76% 1.88% 30 Year Treasury 3.02% 4.11% -2.70% 2.74% 3.07% 3.02% 2.75% 3.97% 2.95% 2.89% 2-10 Year Spread Q YTD Treasuries 2.60% 0.81% 2.4% 1.1% 0.8% 6.0% -3.4% 2.2% 9.8% Agencies 1.95% 1.38% 2.1% 1.5% 1.0% 3.4% -1.8% 2.4% 5.3% Mortgages (Agency) 2.04% 1.00% 2.5% 1.7% 1.5% 6.1% -1.4% 2.6% 6.1% Corporates -0.06% -2.24% 6.5% 6.0% -0.6% 7.5% -1.5% 10.4% 7.5% 2011 Municipals 1.56% 1.05% 5.4% 0.4% 3.3% 9.1% -2.6% 6.8% 10.7% High Yield -4.67% -2.25% 7.5% 17.5% -4.6% 2.5% 7.4% 15.6% 4.4% Market Outlook Fourth Quarter

7 Interest Rates Outlook: Rates Range Bound Interest rates will be range bound throughout the first quarter of 2019: Growth Q3/2018 GDP was revised up to 3.4% Annual GDP will be around 3.0% was revised up one tenth to 2.6%. Growth will be decelerating, but not going negative. This, along with the Fed not raising rates as much as originally anticipated, will make interest rates range bound for The 10 year will be between 2.70% to 3.25% for the majority of Inflation steady - During the quarter, inflation data continued to remain tame. Core PCE, the Federal Reserve s preferred measure of inflation, remains at their target of 2.0%-2.2%. The Consumer Price Index was unchanged in November on a seasonally adjusted basis after rising 0.3% in October. Over the last 12 months, the index increased 2.2% before seasonal adjustment 0.2% ex-food and energy. Fed raising rates On December 19th, the Fed raised rates for the 9th time in this cycle to 2.25%-2.50%. Fed Chairman, Jerome Powell, walked back his forecast for hikes in 2019 to 2 from the original 3, possibly 4. The Fed continues to reiterate they are data dependent for all future rate hikes and all meetings next year will be followed up by a press conference. We are of the view, with growth slowing from 3+% to just above trend, that growth will be 2.4% to 2.6% for 2019 and the Fed will raise one more time in Reduced Demand The Fed remains on pace with its balance sheet reduction schedule. However, Powell has walked back comments that it is off the table to evaluating it depending on data, much like the interest rate decision. The market took this as a positive and rates have stabilized. The Fed is currently on pace reducing $50 Billion per month for 2019 and 2020; however, that is subject to change. Concerns that may change this projection and add volatility to credit markets include: Global growth slowing and Oil price collapse. The British breaking from the European Union (Brexit). Continued trade war rhetoric with China. Continued prolonged government shut down and what that would mean to growth. With consideration of the above, bond portfolios will continue to focus on quality, duration (maturity) management, and issue structures for added safety (TIPS, floating rates, and call features). Active bond portfolio durations should be in the 97%-100% of their benchmarks. Reinvestments should focus on a barbell type of strategy where the focus is on 0-2 years, and 7-10 years, depending on where the 10 year rates are in the range above. If the 10 year is on the lower bound of that range, stay short; if it is on the upper end of the range, go longer. Past performance is no guarantee of future results. This commentary has been prepared for informational purposes. Information and opinions expressed herein reflect our judgment and are subject to change. Wealth Management services are offered through First Midwest Bank. Most wealth management products are not FDIC insured. Market Outlook Fourth Quarter