We live in a Globally Integrated Economy
- As the European population ages and begins to shrink, issues like debt as a percentage of GDP, worker productivity, consumption and investment become harder to improve.
- Political issues like Brexit and the yellow vest movement, trade issues and the persistently strong US dollar are headwinds for growing our exports to the European Union in 2019.
- Although talks seem to be progressing well, our trade war with China is taking a toll on exports to that country and making it difficult for Chinese consumers to buy US produced goods.
- Even though oil prices have recovered somewhat to about $61/bbl from a low of $50 last month, they are still considerably off the high of $86 in October. Lower oil prices may be good for consumers, but they are not good for the energy sector or for countries who rely on exports for hard currency.
All things considered, lower international demand for US goods and services will ultimately reduce economic growth in the US. It will be very difficult for GDP growth in the US to remain above its long-term average of about 2%.
The Fed is “on hold” for most of 2019
- Comments last Friday by Jerome Powell, the chairman of the Federal Reserve Open Market Committee, struck a better tone than his commentary immediately after the December FOMC meeting. He emphasized patience, a commitment to risk management, flexibility and a willingness to pivot aggressively if needed.
- Powel argued that economic data in the US remains generally good but acknowledged that financial markets were signaling concern about elevated downside risk.
- The Fed chairman said “we will be patient as we watch to see how the economy evolves.” This allows the Fed to pause while keeping the option open about raising rates later in the year.
- His commentary was reinforced in the release of the December FOMC minutes.
Based on what we know now, we think the Fed is on hold for the first half of 2019 and therefore it is unlikely that the spread between the fed funds rate and the 10-year US Treasury bond yield will turn negative as has happened before every recession in the post-war era.
Above trend GDP growth will moderate in 2019 and 2020, eventually declining to below-trend
- At the same conference where Chairman Powell spoke last week, former Fed Chair Ben Bernanke offered up this concise economic forecast for 2019 and 2020:
“Well, I think we have an excellent chance of breaking the all-time record for an expansion – a 10-year expansion – the middle of next year. It’s likely that the economy will grow more slowly in 2019 than in 2018 and maybe even more slowly in 2020. This is not something that is news. I mean, we’ve anticipated this for a long time because the fiscal policy, in particular, that was enacted close to a full employment starting point – we knew that barring changes in the law that that stimulus was going to be dying down over time. And that’s certainly going to be slowing growth, all else equal.”
We are forecasting slower economic GROWTH and lower S&P 500 Earnings Per Share GROWTH in 2019.
Stay the course
- We are not adjusting our recommended asset allocation weight between stocks and bonds. Our 2019 expectation is for bond returns to be roughly equal to the coupon rate and for US large cap stock returns to be in the range of 7%-10% including dividends. If your allocation currently favors stocks over bonds, we see no reason to make a change to your allocation targets.
- Within our equity strategies we are moving to a slightly more defensive posture. Defensive sectors like healthcare, utilities and consumer staples tend to do better than more economically sensitive sectors like industrials, technology or consumer discretionary when growth rates are slowing.
Inflation dips in December on lower oil prices.
- Consumer price inflation fell 0.1% in December as oil prices fell over 11%. Excluding food and energy, core inflation held steady at 0.2% for the month.
- On a yearly basis, inflation is moderating. The annual rate of inflation is 1.9%, down from 2.2% in November and 2.5% in October of 2018. Annualized core inflation is unchanged at 2.2%, holding steady for the last three months.
- Labor productivity needs to increase before we begin seeing any meaningful wage pressure. So far in this extended recovery, investment in machinery and technology has been lagging other post-recession expansions.
December employment stronger than expected
- The US labor market added 312,000 new jobs in December, well ahead of expectations.
- Strong gains in construction, leisure/hospitality and education/healthcare propelled much of the gain.
- The unemployment rate increased to 3.9% from 3.7% as more potential workers entered the labor force. The participation rate, or the percentage of the population who are in the labor force, increased to 63.1% from 62.9%.
- The JOLTS report from November indicates that there are more job openings, 6.888 million, than there are total persons unemployed, 6.294 million.
ISM manufacturing Index suggests slower growth in 2019
- The ISM manufacturing index dropped from 59.3 in November to 54.1 in December, well below the consensus forecast.
- There was a sizable decline in new orders, which fell from 62.1 to 51.1. Production, employment and inventories also fell. The prices-paid index declined from 60.7 to 54.9, likely reflecting lower global oil prices.
- It’s important to keep the decline in perspective. The ISM index can be useful in assessing recession risks, and December’s drop may appear concerning. But we view it more as a disappointment than a disaster. An ISM index north of 43.2 over time is consistent with increases in GDP.
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