2019 First Quarter: 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.

Global Markets

European Ensemble

As a bloc, the European Union is second only to the U.S. in its share of global GDP output and currency circulation.

CHALLENGES AND OPPORTUNITIES

The biggest impact on much of northern Europe’s economic growth rates in 2019 rests on broader concerns. A pragmatic Brexit outcome would be a boost for everyone given the high levels of trade between the European Union and the UK. Ulti­mately, I consider this a likely outcome. The other exogenous issue (specifically for northern European countries such as Ger­many, the UK, Holland, and Scandinavia) is avoiding a broader global trade war (as has occurred between the U.S. and China).

Progress to date in bilateral trade discussions between China and the U.S. have helped buoy global markets, including those across Europe. Part of the reason is that a material part of the region’s growth (especially northern Europe) has come from exports, spe­cifically to the emerging markets (especially China) and the United States. These exports have been boosted by the relatively cheap value of the euro over recent years. However, this also indi­cates that Europe can be an attractive supplier of a broad range of goods and services for the global market, a view which is at odds with the pessimism surrounding Europe’s potential for innovation and productivity.

Avoiding trade tensions is therefore crucial for the immediate outlook for the European economy. Whilst the political leader­ship of both the European Union and the United States have clashed more regularly in recent years, the United States-Mexico- Canada Agreement (USMCA), and ongoing bilateral China/United States trade discussions indicate that pragmatic outcomes are possible. In short, it would appear the bark of negotiating politi­cians is worse than their bite.

Even though outcomes surrounding the ECB, Brexit, and external trade factors appear to offer more opportunity than threat, the average investor remains heavily underweight towards Europe. As such, investors are inevitably very concerned about the status of the European political backdrop, as it appears cursed by the confluence of populism and debt.

US/China Trade the #1 Influence

There has been a major shift in the U.S.-China trade dynamic since the market sell off in December, which has once again led to a debate on how much the market plays into President Trump’s deal making. As the market was hitting new highs throughout 2018, Pres­ident Trump and others within his administration were repeatedly taking a hardline stance with China, pushing for major structural reforms and threatening an ever growing list of tariffs and other punitive actions. More recently, there has been a push to strike a deal and ease some of the trade tensions.

Politically, the advantages of securing a deal in the short term are there for both sides, but opportunity for miscalculation is height­ened in the long term. Reaching a deal provides a market boost in the United States and plays well for China’s Xi Jinping for pre­serving (for the time being) the relationship with China’s largest market. In the longer term, incentives do not align as well. Xi Jin­ping’s term as China’s leader will continue well beyond Trump, but the United States may experience a change in administration with the 2020 election. From that perspective, the scope of China’s con­cessions and commitment can be limited if they decide to “weather the storm.” A less comprehensive deal or a backing away from cer­tain commitments may take us right back to tariff escalation or even significant other economic restrictions down the line. This fight could re-emerge right in the heat of the 2020 presidential campaign, which can serve to damage Trump’s economic message or could provide a political incentive to once again increase pres­sure on China. We expect China trade headlines and the interplay with domestic politics to remain in focus for the foreseeable future, even with an initial deal struck.

Global Hotspots

Venezuela’s political crisis and Indian-Pakistani tensions could provide a surprise to the global markets.

The Economic Outlook: Slower, With Downside Risks

As delayed economic data releases arrive and fresh figures pour in, the 2019 growth outlook has appeared somewhat softer than anticipated a few months ago. Fiscal stimulus (tax cuts and increased government spending) was a major force propelling overall growth in 2018. However, the impact was expected to fade in 2019, with GDP growth slowing to a more sustainable pace (one driven by the natural growth in the working-age population).

Consumer spending slumped in December, with only a partial recovery in January, when confidence was rattled by the partial government shutdown. Still, the fundamentals of the household sector remain in good shape. Mild weather helped boost job gains in January, while poor weather dampened job growth in February – the underlying trend remains moderately strong. Wage growth has continued to pick up and lower gasoline prices have added to consumer purchasing power. Consumer sentiment rebounded fol­lowing the end of the government shutdown.

Slower global growth and trade policy uncertainty appear to have dampened business fixed investment in early 2019. Orders and shipments of nondefense capital goods are on a softer track. Residential home­building weakened over the course of 2018, but a sharp drop in mortgage rates should help in 2019.

Q&A: What’s in the Cards for Oil?

Pavel Molchanov, Senior Vice President, Energy Analyst, Equity Research

Q. OPEC and Russia agreed late last year to cut crude production by a collective 1.2 million barrels per day (bpd) for the first half of 2019. To what extent has the group been fulfilling its promises?

A. By way of historical background, OPEC generally has a mixed track record for member compliance with its production deci­sions. The smaller oil producers in the group rarely cut production in accordance with the official pledges. However, as a practical matter, only a handful of OPEC countries truly matter when it comes to managing global oil supply. Saudi Arabia is by far the most important, and for the past two years it has played a very proactive role in this regard.

Based on data from the past several months, we estimate that Saudi production in the first quarter of 2019 is tracking to be nearly 600,000 bpd less than in the fourth quarter of 2018. This alone represents half of the total pledged production cut across all of OPEC and Russia. So, it is clear that Saudi Arabia is serious about propping up oil prices – it is not just lip service!

Beyond Saudi action, let’s also bear in mind that several OPEC countries are experiencing organic production declines even without deliberate curtail­ments. Case in point: Venezuela. This country has already had the world’s steepest drop in oil pro­duction since 2015, for purely domestic reasons. Amid the cur­rent political and economic crisis, the national oil company, Petróleos de Venezuela, S.A. (PdVSA), continues to suffer from mismanagement and severe cash flow shortages. Meanwhile, production in Libya and Nigeria is perennially choppy due to recurring violence around oilfields. Looking past this choppiness, the longer-term trend in both countries is downward due to insufficient foreign investment given the hazardous conditions.

Q. The International Maritime Organization (IMO) has set regulations to cut sulfur in fuel used by the marine industry starting in January 2020. How are shipping firms and refiners preparing for this? How do these regulations affect the global oil market?

A. It is safe to say the oil market, for the time being, is not remotely focused on what will happen in 2020. However, it is important to underscore just how impactful the IMO 2020 policy will be. We estimate it will effectively erase 1.5 million bpd (or 1.5%) of global oil supply, a very meaningful supply reduction. Put another way, this is as much supply impact as what Venezuela has caused over the past four years. Some of this, in fact, will likely be felt toward the end of 2019.

To clarify, the total amount of high-sulfur fuel used in long-dis­tance marine shipping is currently around 4 million bpd. Of this amount, a portion will be processed in newly built units at refineries and another portion will be handled by shipboard scrubbers, which ship owners are in the process of installing. There will be some “cheating,” at the risk of facing sizable fines from regulators, and, as noted earlier, some fuel will simply be rendered unusable.

Another concern, given the dislocations that this may cause, is that some countries could try to back out of the new rules. That, to clarify, is not legally possible because of the binding nature of the underlying treaty known as the International Con­vention for the Prevention of Pollution from Ships. Moreover, the IMO has made it clear that implementation will not be delayed past January 2020.

Q. Putting everything together, what is your oil price outlook over the next 12 months and what wild­cards could derail that outlook?

A. Oil prices have already bounced back year-to-date from their recent lows but remain well below their 52-week highs. The oil futures curve is relatively flat, indicating minimal upside from current levels over the next five years. We tend to stay away from making short-term (weekly or monthly) com­modity calls, but we are of the view that prices will be meaningfully higher in the second half of 2019.

Our forecast for the second half of 2019 is for WTI to average $70/Bbl and Brent $80/Bbl. Looking out to 2020, we think oil will reach cyclical highs, with WTI averaging $93/Bbl and Brent $100/Bbl. To be clear, such prices would be unsustainably high given the adverse impact on global demand (for example, con­sumers shifting to smaller cars and electric vehicles). That, in fact, is the whole point. We believe that oil prices in 2020 will have to rise to levels that begin to put a damper on demand, in large part because IMO 2020 will create a temporary situation of inadequate supply. While visibility beyond 2020 is limited, our long-term forecast of $75/Bbl WTI and $80/Bbl Brent reflects a “happy medium” of prices that are high enough to enable the industry to sustain supply growth but not so high as to sharply curtail demand.

As always, there are plenty of wildcards of which we need to be mindful. For example, a sudden spike in the U.S. dollar would, all else being equal, put downward pressure on oil prices. Similarly, a wide-ranging economic slowdown would naturally have a nega­tive effect on demand. On the flip side, there is always the risk of unforeseen supply disruptions, such as what we mentioned ear­lier vis-à-vis Libya and Nigeria. Finally, geopolitical uncertainty swirling around Iran (U.S. sanctions, etc.) could potentially lead to an even higher-impact disruption

Jeffrey Saut Chief Investment Strategist
Michael Gibbs Managing Director, Equity Portfolio & Technical Strategy
Nick Goetze Managing Director, Fixed Income Services
Scott J. Brown, Ph.D. Chief Economist
Chris Bailey European Strategist, Raymond James Euro Equities*
Doug Drabik Managing Director, Fixed Income Research

*An affiliate of Raymond James & Associates, Inc., and Raymond James Financial Services, Inc.
All expressions of opinion reflect the judgment of Raymond James & Associates, Inc.,

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