2019 Equity Market Outlook: Headwinds or Tailwinds?

As we move into the New Year, the outlook for the financial markets is beginning to feel like a classic game of heads or tails. This simple yet effective game has been used throughout history as a means of deciding between two alternatives, and is often used to resolve a dispute between two parties. It has also become a staple in Statistics 101, where we get our first lessons in probability, or the chance of occurrence. Whether we’re talking about settling a dispute or calculating the probability of an event taking place, both are highly relatable to the world around us as we head into 2019.

This past year grounded complacent investors, and asset prices alike, as both retreated from one of the most extraordinary expansions in market history. Slowly and steadily, stocks had been on the rise, with U.S. equities reaching record levels in January before sputtering through emotion-filled sell-offs for most of the year. Mounting concerns over trade tensions with China and slowing global growth consumed the news headlines as we watched markets plummet and significant intraday movements became the norm. We now look ahead with much less certainty than in prior years. As major market developments unfold, opportunities and challenges

remain abundant. Looming challenges include Brexit and the Italian debt crisis in Europe, slowing growth in China, and unresolved trade negotiations with a bipartisan government in the U.S. On the brighter side, U.S. earnings growth remains positive, and supportive fiscal policy, lower oil prices, and increasing wage growth all bode well for consumer spending. As one crosses their fingers as they call “tails” in a coin toss, we look ahead with hope that tailwinds prevail, the bull continues to run, and we all have a prosperous new year.

RECESSION: POSSIBLE BUT NOT LIKELY

If the current economic expansion continues past June, it will become the longest expansionary period on record. So, many investors ask, when will the next recession occur? The likelihood of entering a recession, a period of declining economic activity, usually lasting two quarters or more, does not depend on the length of the expansion. That is, we are never “due” for a recession. There are few signs of a pending economic downturn on the immediate horizon, but economists have raised the odds of a recession beginning in late 2019 or 2020 – still not likely, but also not out of the question. The stage is typically set for a recession by a period of over-investment or mal-investment, often fueled by increased leverage. Fed policy is often a factor, typically by raising short-term interest rates too rapidly or by previously raising them too slowly (and then having to play catch-up). In past decades, sharp increases in oil prices were also a catalyst, dampening consumer spending .Every downturn has its own story.

FISCAL STIMULUS

The Tax Cuts and Jobs Act of 2017 (TCJA) lowered the corporate tax rate and many economists remained doubtful of the impact it would have on the economy since firms were generally flush with cash and borrowing costs were low. Research has shown that corporate tax cuts are more likely to increase share buybacks and dividends than to fuel capital expenditures and, for the most part, that was the case in 2018. However, business fixed investment, while uneven from quarter to quarter, was generally stronger.

The other component of the TCJA was reductions in personal tax rates, which will expand in early 2019. While the impact will vary across income levels and regions, overall consumer spending, which accounts for 68% of overall economic activity, should see a boost in the first half of the year as a result. The impact of fiscal stimulus will fade over time, but job gains and wage increases are expected to drive consumer spending.

As 2018 came to a close, the US equity market was under pressure due to uncertainty regarding the trade war with China, concern over US economic growth sustainability, a focus on the Fed’s tightening cycle, and moderating economic growth abroad. We recognize the heightened risk environment, but feel the current risk/reward is an opportunity for equities. We expect US economic concerns to be proven premature as USGDP is still likely to grow over 2% in 2019. Earnings growth for the S&P 500, while slowing from the unsustainable 20+% growth rate of 2018, will still be healthy as we project 5-6% growth for the year. Valuation further supports a positive bias with the S&P 500 price to earnings ratio (P/E) of16x on the last twelve months estimated earnings attractive versus a 15-year average of 16.2x. Our base case S&P 500 target of 2957 by year end 2019 renders 16% upside from the 12/17/18 close of 2546. Despite our bullish posture, we admit a lot needs to go right in the year ahead to achieve our target. With delicate issues, such as the US/China trade war in-play, a volatile road lies ahead. We widen the range between our potential bull and bear case scenarios to account for the heightened risk environment. Our bear case of 2415 is 5% below the 12/17/18 close and would push the equity market total decline to 17.6% from the September 2930 closing high. In our bull case scenario, the 3305 target renders a ~30% gain from the 12/17/18 close. With the issues delicate and outcome uncertain, especially regarding trade, our probability odds in our bull case are lowered to just 5% while our bear case odds increase to 30%. Our base case odds are the highest at 65%. Progress on the trade front could alter our cautious probability bull/bear case odds dramatically

US/China Trade the #1 Influence

The trade war is expected to remain the center of investor focus in 2019. Despite the G20 “trade-truce,” challenges to a “deal” are elevated with both sides appearing hardened regarding intellectual property rights. For this reason, reaching an agreement by the 90-day deadline suggested by President Trump is unlikely. Nonetheless, we feel the two sides can/will deliver a message of progress to reassure the financial markets as the deadline nears. With the stakes (to global sentiment) high, we are optimistic both sides can arrive at acceptable terms as the year progresses. Stock market volatility will likely remain elevated with the path to an agreement rocky.

US Macro: GDP Expected to Advance Over 2% in 2019, Providing Support for US Stocks

Investor economic concern is heightened with housing trends softening and initial jobless claims ticking slightly higher. The softening trends are likely noise in our opinion; and with the economy late cycle, uncertain readings are not a surprise. Conversely, other economic readings such as unemployment, leading indicators, consumer confidence, and ISM surveys all point to a healthy environment. The flattening yield curve, often a signal of pending economic weakness in the future, adds to investor angst. The narrowing spread between the 2-year and 10-year yields stoked concern in early December. We are watching yield spreads; but since we put more weight in the 10-year yield and the US 3-month yield spread, we are not overly concerned at this point with it still above the zero line. Long lead times to recessions after previous yield curve inversions and false signals cause us to refrain from over-concern at this point as well. Nonetheless with investors focused on the shape of the yield curve, it will influence equity market direction, at least for short periods. The predictive power of yield curve inversion and forward stock market returns has a mixed history. Many of the occurrences of an inverted yield curve were at or near stock market peaks in 1966, 1968 ,1973, 1980, and 2000. However, stocks moved higher after or during inversion periods in late 1966, 1967, 1989, and 2006. The yield curve is an important indicator to watch, but using it as a sole source for stock market direction is a failed approach in our opinion.

Our belief that inflation will remain anchored and interest rates will not run away to the upside further supports a positive bias. Low global bond yields and the likelihood of only one Fed rate hike in 2019 should keep the US 10-year from spiking again. As a reminder, in 2018 a jump in interest rates triggered both 10% draw downs in the equity market. In addition to trade and economic worries, political brinkmanship due to a split-Congress will add to the list of stock market headwinds as noise around impeachment, government shutdowns, and approval of the US, Mexico, and Canada Agreement (USMCA) will garner headlines. Fundamentally, earnings are set to slow from the 20%+ 2018 growth. There has been plenty of noise around “peak earnings,” but it is a mistake to confuse “peak earnings growth” with “peak earnings.” We estimate earnings will grow 5.2% in 2019 to $169 per share. Such growth, if realized, is adequate to support higher equity prices.

2018 U.S. Equity Market: Influencing Factors

Outlook: Following the sharp declines in equities (both domestically and globally), we find the current risk/reward as attractive. Overall, U.S. economic data and earnings remains supportive of upside in equities. However, in the near-term, the market is likely range bound with volatility continuing. Trade tensions remains the biggest potential headwind to markets. However, the slowdown in global growth, earnings growth deceleration, rising inflation (although modest at this point), rising USD, potential for Fed mistake, corporate debt, and yield curve inversion fears leading to a recession continue to be market forces influencing negative sentiment. With the S&P 500 currently in corrective territory and small caps and NASDAQ in bear market territory, we believe markets likely remain choppy and do not expect markets to race back to the highs seen in September until some resolution on trade. However, we believe the positives continue to outweigh the negatives for equities. From the close on December 17th, our base case assumption for 2019 assumes ~16% upside in equities (before dividends). For 2019, we are assuming earnings continue to move higher (although at a slower y/y growth rate than 2018) and P/E reverse course and expand (rather than contract as we witnessed in 2018). Our estimated year-end S&P 500earnings are $169. Applying a 17.5x LTM P/E multiple, our fair value estimate for year end 2018 for the S&P is ~2,957.

Potential Positive Forces

1) Earnings are still expected to grow in 2019. Fiscal stimulus such as infrastructure spending may spur further growth in earnings.

2) U.S. macro environment remains on solid footing with 2019 Real GDP expected to grow at 2.6% y/y.

3) The U.S. economy remains strong (job growth; non-manufacturing strength; manufacturing recovery) mixed with low interest rates and low inflation (despite both modestly rising) on historical measures.

4) Valuation turns from a headwind to equities to a tailwind.

5) Low oil prices may be a positive boost to consumers

6) U.S. leading economic indicators remains positive

Potential Negative Forces

1) U.S. Protectionism remains the top fear of the market right now– tensions with China may limit upside in equities as the full impact of rising

tariffs are not reflected (still a small portion of U.S. GDP). If 25% tariffs are implemented on all goods between the US and China, could be another

2-4% hit to S&P 500 earnings.

2) Peak earnings narrative—earnings growth is expected to slow significantly in 2019 from the elevated rates seen in 2018

3) Curve inversion– spread between 2-year and 10-year continues to narrow and is currently at its lowest level since the prior crisis—spreads tend

to invert prior to recessions

4) Central bank errors and limits: Monetary policy error if Fed tightens too rapidly or too slow (inflation picks up); ECB likely to begin tapering

5) U.S. budget deficit limits flexibility if economic conditions deteriorate

6) Dislocation of synchronized global growth– Emerging markets and China under pressure with PMI topping

S&P 500 Fair Value 2019 Year-End Level: Base/Bull/Bear Case: 2957/3306/2415

Base Case (65% Probability): In our base case scenario for 2019, trade issues linger but enough progress is made (by year-end) to allow a more positive tone, the US economy does not falter, the Fed pauses the tightening cycle after one move in 2019, the 3-month to 10-year yield curve does not invert, and earnings rise as expected. We apply a P/E of 17.5x P/E to $169 in earnings to reach 2,957 (+16% from 12/17/18). Our P/E adequately discounts late stage economic risks which will likely linger. We place a 65% probability of this scenario playing out.

Bull Case (5% Probability): A “Goldilocks” environment where trade differences are worked out more rapidly (and without as many issues as feared), the US economy hits its targets, inflation remains muted, the yield curve steepens in a controlled fashion, the unemployment rate stops falling (allowing the Fed to pause the tightening cycle), and investor optimism returns. We use a 19x P/E, which was the P/E at the September peak and has been the historical median P/E when inflation is in the 2-2.5% range. Earnings surpass our estimate and reach consensus forecasts of $174. Applying 19x P/E to this $174 earnings gets a 3,306 bull case scenario (+30% from 12/17/18). We give a low 5% probability to this scenario.

Bear Case (30% Probability): In our bear case scenario, the trade conflict escalates which weighs on sentiment, slows economic and earnings growth (without entering a recession), the US10 year – 2 year yield spread inverts, and the Fed stops tightening and leans towards looser policy (which helps to limit the downside in stocks). In this scenario, we feel earnings will be flat with 2018 (~$161). Negative sentiment could push the S&P 500 P/E down near 15x (~9% below the historical average of 16.5x). Applying a 15x P/E multiple to $161 earnings results in a bear case scenario of 2415 on the S&P 500 (-5% from 12/17/18 closing price before dividends and -17.5% from the 2930 September peak). We apply 30% odds to this outcome given the uncertainty.

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