Letter from the Chief Investment Officer
Reckoning with Records
Despite numerous headwinds, 2019 is gearing up to be a celebratory year with record-breaking achievements on many financial and economic fronts. In particular, we just toasted the S&P 500 as it celebrated the ten-year anniversary of the secular bull market in March.
Following last December’s worst equity performance since 1933, concerns of an impending recession, tightening monetary policy, and a trade war with China were muted, allowing risk assets to recover from the December 24 lows.
The U.S. economy and various financial markets are poised to achieve historic milestones, some set to take place in the upcoming quarter. Consensus from the Raymond James Investment Strategy Committee is that markets remain favorable, especially for investors maintaining a long-term time horizon. However, given the speed and magnitude of the first quarter rebound, the path ahead is likely to remain challenging.
The U.S. is the beacon of the global economy, with positive growth expected for the year. 2019 growth is expected to be 1.9%, according to Dr. Scott Brown. Should the expansion continue past June, it will be the longest economic expansion on record.
Robust job growth, healthy consumer spending, elevated business and consumer confidence, and fiscal stimulus support our positive view. A “patient”, flexible Fed leads us to assign a 25% probability of a recession over the next twelve months. In fact, April could “legendize” the Fed for navigating the longest tightening cycle ever engineered without causing a recession.
Dr. Scott Brown recently reported that the Fed is on hold for the foreseeable future, reflecting signs of slower-than-expected growth and downside risks. The fed funds futures are pricing in some chance of a rate cut by the end of the year.
Our expectation of a trade agreement between the U.S. and China should supplement growth globally as trade uncertainty fades. In the absence of an agreement, a softening global economy, that currently shows signs of strain, has the potential to spill over to the U.S.
Despite the slowing ascent of equities, with intermittent periods of downward pressure, we remain unwavering in our expectation of a higher equity market by year end. In fact, Mike Gibbs’ year-end target of 2,946 gives the market a realistic opportunity of returning to record highs. Supporting equities is his expectation of record earnings again in 2019. Our conservative $166 2019 S&P 500 earnings estimate is approximately $4 higher than the record set last year. While earnings growth may struggle during the first quarter, and potentially move negative, Jeff Saut sees earnings expanding in the second half of the year. The average stock is still expected to post positive earnings growth for both the quarter and the year, a better barometer of the health of corporate earnings.
Internationally, we favor the U.S. over other developed markets, as those economies continue to exhibit signs of weakness. Chris Bailey* believes that the Brexit debate is likely to edge towards a sensible compromise that will avoid a ‘no-deal’ scenario. Meanwhile, this May’s European Parliamentary elections will see populist parties make further gains although not take control.
Looking at emerging market equities, the recent rally is likely to continue, especially if a U.S.-China trade compromise comes to fruition. China is attempting to stimulate its economy via pro-growth monetary and fiscal stimulus with the budget deficit challenging record highs of 4% of GDP. While the U.S. dollar bull market run has reached a record duration, celebrating its 11-year anniversary, the rally is likely to see a period of consolidation. More tempered Fed policy and fewer “upside” surprises to U.S. economic growth forecasts are a recipe for a pause in dollar growth. Our year-end target for the EUR/USD is 1.15. Stabilization of the dollar is positive for all non-U.S. equities.
Despite healthy U.S. economic growth, record national debt, and a gradual reduction in the Fed’s balance sheet, the 10-year U.S. Treasury yield remains well below 3%. Nick Goetze expects rates to be capped through the end of the calendar year at 3.00%, due, in part, to the wide disparity between domestic yields and developed world sovereign debt creating very strong global demand at current levels and the lack of inflationary expectations. If we see a normalization of global interest rates relative to our own and an uptick in inflationary expectations, a logical next cap on rates, albeit at higher levels, would be the massive demand from underfunded pensions and the Baby Boom generation seeking stable income with lower volatility in retirement.
With slowing global growth and nascent inflationary fears, yields overseas are likely to remain depressed for the foreseeable future. In fact, the University of Michigan inflation expectations survey for the next five to ten years recently fell to 2.3%, tying the lowest level on record. Doug Drabik expects higher interest rates to continue to face major headwinds likely keeping them range bound and low. The 2-10 year part of the Treasury curve seems to be pricing in one to two Fed rate cuts, thus giving the potential to steepen the curve from the current mark. Although the Treasury curve remains flat, the municipal and corporate curves are more positively sloped offering opportunities in the intermediate part of the curve.
Although credit-market spreads have narrowed, we believe companies and countries with modest leverage and strong balance sheets should outperform. Simply buying yield will not work. James Camp* believes that credit fundamentals are paramount as leverage has increased materially with a record 50% of investment-grade bonds in the BBB-credit rating range – slightly above ‘junk.’
Record oil production in the U.S. is expected to continue, with average daily production forecasted to reach approximately 12 million barrels per day (mm bpd) by year end. While this would normally place a cap on oil prices, two market dynamics are supportive. First, OPEC production cuts have reduced overall supply. In particular, sizable cuts by the largest OPEC producer, Saudi Arabia, are adding to undersupply. In fact, total OPEC production is at its lowest level since 2015.
Second, new global sulfur emission standards taking effect in January 2020 will effectively erase as much as 1.5 mm bpd of supply. This, combined with our expectation that global oil demand growth will remain healthy, could allow oil (WTI) to move north of $70/ barrel by the end of the year, according to our energy research team.
Moving forward, it is not feasible for markets to continuously rise or fall, so don’t get caught up in the momentary noise. While records can be broken, we can’t lose focus on what the long-term trends are telling us. Staying disciplined during times of uncertainty and times of complacency is an essential characteristic of a successful investor.
Lawrence V. Adam, III, CFA, CIMA®, CFP® Chief Investment Officer, Private Client Group