With the New Year fast approaching, we are taking this opportunity to share with you — our valued clients and friends – Pennsylvania Trust’s 2019 investment outlook. But first, we would like to review the highlights (and lowlights) of our 2018 forecast, since what we got right and what we got wrong certainly impact the 2019 outlook.
Looking Back at 2018
In our economic outlook for 2018, we noted that the U.S. unemployment rate was historically low at 4.1% and “likely headed lower in 2018.” This proved to be accurate, as the U.S. unemployment rate declined in 2018 to 3.7%. Noting that fiscal policy (in the form of corporate and individual tax relief) would provide a substantial boost, we also forecast that the “U.S. economy will continue to grow nicely during 2018.” This, too, was on the mark as U.S. GDP has grown by 2.2%, 4.2% and 3.5% in the first three quarters of 2018 respectively. Growth at or near 3% is also expected in Q4. If such growth materializes, GDP growth in the U.S. will be at or above 3% for 2018 — an impressive feat judged by the last ten years.
While we got the U.S. economic forecast essentially correct, including the fact that no recession would occur in 2018, where we erred was in believing (along with the International Monetary Fund and many others) that “global economic growth will remain strong in 2018.” In 2017, we witnessed a rare period of synchronized global economic growth which appeared to be accelerating. Unfortunately, in 2018 there was a de-synchronization of economic growth, with the U.S. still growing nicely but with many of the rest of the world’s economies slowing. During 2018 Q3, for example, economic growth in the eurozone slowed to 0.6%, the weakest quarter since 2013. The largest economy in the eurozone — Germany — actually saw its economy contract in the third quarter. Japan’s economy also contracted in the third quarter. Chinese economic growth fell well short of expectations, as the negative impact of the trade war gradually took its toll.
As to our 2017 equity outlook, we forecast that “the equity bull market will continue in 2018, albeit with markedly increased volatility.” Again, 2018 performed pretty much as expected — at least until the last six weeks or so. The U.S. equity bull market did continue in 2018, as all major U.S. indices made new all-time highs, as recently as early October in the case of the Dow Jones Industrial Average. And volatility markedly increased. The markets experienced two separate 10% (or greater) declines in 2018 after none in 2017. According to Barron’s, moreover, “there were a total of 12 days in which the VIX (the CBOE volatility index) spiked 20% or more during the year.”
Of course, the jury is still out on our ultimate call that the U.S. equity bull market was unlikely to end in 2018. While we did correctly note a risk to the market of “U.S. trade policy becoming more jingoistic,” the magnitude of the risk proved greater than expected. This contributed to 2018 being a less rewarding year for investors than we had forecast.
Lastly, our cautious bond outlook proved warranted. We correctly forecast rising bond yields and falling bond prices. In particular, we predicted the yield on the 10-year U.S. Treasury note would potentially reach 3% and perhaps higher, which it did.
So, as we close out 2018, what’s next? As our outlook for stocks and bonds depends in large part on our economic outlook, we begin there.
As we conclude 2018, the U.S. economy is still on solid footing. The unemployment rate is historically low at 3.7% (a low since December 1969), and may be headed lower in 2019. Jobless claims, likewise, are historically low. Wages are finally rising at about a 3% rate, the best growth in almost ten years. And household net worth, accordingly to the Federal Reserve, hit record highs in 2018 Q3. Not surprisingly, U.S. consumer confidence has hit 18-year highs over recent months and remains a positive indicator for solid GDP growth in 2019, as consumer spending accounts for about 70% of GDP.
The median U.S. GDP forecast for 2019 hovers around 2.5%, slower than 2018 but still solid. It follows that most economists and strategists do not believe a U.S. recession is likely in 2019 — and neither do we. Among other things, the manufacturing and services sectors of the economy remain strong, along with the consumer.
That said, some cracks in the U.S. economy are starting to appear — particularly in the interest-rate sensitive housing and automobile industries. This underscores that consensus U.S. GDP forecasts for 2019 are subject to downward revision depending on how aggressively the Federal Reserve raises interest rates in 2019. With overall core U.S. inflation still near the “Goldilocks” 2% level and jobs plentiful, the Federal Reserve may proceed more cautiously in 2019 with rate increases than in 2018. But if it does not, then fears will grow that a policy error could trigger a recession.
Looking outside the U.S., the economic outlook is not particularly good. In Europe, Germany and Italy are hovering near recession. Brexit uncertainties, particularly the possibility of a “no deal” Brexit, create cloudy outlooks for the U.K. (and the entire European Union). ECB President, Mario Draghi, recently said as the ECB cut its economic growth forecasts. “It’s a climate of great uncertainty.” Recent economic data from China paint an equally gloomy picture, as November retail sales grew at their slowest pace in 15 years while Chinese factory output weakened to an almost three-year low. If progress is made on a trade deal, then world economic growth will improve; but if there is no end to the trade war, the world economic picture will continue to deteriorate in 2019.
Even though the S&P 500 was up over 10% (including dividends) for the year through September 30th, driven by very strong corporate earnings growth, the fourth quarter correction has wiped out those gains and creates doubt about whether the S&P 500 will be able to finish the year with positive returns. Continued very strong corporate earnings growth in 2018 Q3 (reported in Q4) was ignored as investor sentiment turned gloomy. Indeed, pessimism among investors jumped to its highest level in over five years during the week ended December 12th, according to the latest American Association of Individual Investors survey. The number of bullish investors, for example, plunged to 20.9% while those with bearish outlooks increased to 48.9%. Reflecting this extreme negative sentiment, investors pulled a record $46 billion from U.S. equity funds during the week ended December 12th, according to Lipper. Clearly, many appear now to believe the bull market may be over.
Our base forecast is that the U.S. equity market likely will produce positive returns in 2019, albeit with continued volatility. Extreme bearish sentiment, of course, can mark a market bottom. Whether it does or not, we believe that the S&P 500 now is trading at reasonably attractive valuation levels (approximately 15x 2019 consensus earnings estimates). While earnings growth will slow markedly in 2019, S&P 500 companies are still expected to show 7-8% EPS growth on the strength of 5-6% revenue growth. While we do not issue price targets, we do note that, according to Barron’s, the mean 2019 forecast of Wall Street strategists for the S&P 500 is 2975, up over 13% from current levels. Some strategists, including JP Morgan’s strategist, look for the S&P 500 to hit 3100 next year.
Admittedly, there are potential risks to the equity markets in 2019 which include: federal government policy mistakes (either the Trump Administration’s handling of its tariff negotiations or the Federal Reserve raising rates too aggressively, or both); and escalating discord and dysfunction in Washington D.C. with a divided federal government (producing uncertainty over a possible partial government shutdown, debt ceiling negotiations, and headline risk stemming from more investigations of the Trump Administration). Outside the U.S., there will be a Brexit overhang until at least March 29th, the deadline for the U.K. to leave the EU. How this issue gets resolved, along with how the tariff issues are resolved, will weigh heavily on whether the current economic slowdown in Europe worsens or improves. That, in turn, will have much to do with how the European stock markets perform in 2019. Likewise, Asian markets will be assessing the economic health of countries such as Japan and China — which again depends heavily on if, when and how the trade and tariff issues are resolved.
Geopolitical risks, of course, also remain, whether with North Korea, China, Russia or in the Middle East. Any such geopolitical conflict could cause a temporary market setback.
Clearly, there are downside risks to our base forecast. Given the uncertainties that exist, active management will continue to be of great importance, as will proper asset allocation. We stress the benefits of a well-diversified portfolio that includes large, mid and small cap equity exposure in addition to international equity exposure. That said, we advise a focus on high-quality U.S. large-cap stocks, particularly those with the ability to generate strong levels of free cash flow.
The secular, 30-year bond bull market likely came to an end after the Brexit announcement in July 2016. Bond yields, while still low by historical comparisons, have risen substantially from their July 2016 lows. We see this trend continuing in 2019, with the path of yields gradually rising (and prices gradually declining) — although the path will not be linear. Even assuming sub-par returns for bonds in 2019, we continue to believe that bonds can play an important part of a balanced investment portfolio as they serve as a hedge against the volatility inherent in the equity markets.
Uncertainties abound at the moment. And what is certain — that the rate of growth in the U.S. economy and in U.S. corporate earnings will slow in 2019 — is not particularly helpful. Much will depend on the future course of trade/tariff negotiations and on Federal Reserve policy. If we have a resolution of the trade issues, and if the Federal Reserve does not commit a policy mistake, then 2019 should be a good year for investors, albeit with pullbacks, as the markets now trade at reasonable valuations and the economy and earnings are still growing. We will be closely monitoring events as they develop but urge clients to remain focused on their long-term goals.
We wish everyone a happy New Year and encourage clients to contact their portfolio manager with any investment questions, concerns or perspectives as 2019 unfolds. You may reach us at 610-975-4300, or email firstname.lastname@example.org.
Mr. McFarland is President, Chief Executive Officer, and Chief Investment Officer of Pennsylvania Trust.
Disclosure: This Commentary represents a review of topics of possible interest to Pennsylvania Trust’s clients and is not personalized investment advice. It contains Pennsylvania Trust’s opinions, which may change following the date of publication. Information obtained from third-party sources is assumed to be reliable but is not guaranteed. No outcome — including performance — is guaranteed, due to various uncertainties and risks. This document is not a recommendation of any particular investment. Investment decisions for clients are made on an individualized basis and may be different from what is expressed here. Past performance is no guarantee of future results.