US economic growth data for the final quarter of 2018 showed an annual rate of 2.6%, down on the 3.4% notched up in the previous three months but still pretty solid. For the calendar year, GDP growth was a robust 2.9%. Inflation remains muted running at an annual rate of only 1.6%. Wage growth though is running at 3.5% per annum but prices are obviously not catching up. This implies that further tightening from the Fed is dead in the water for now, though not such good news maybe for US corporate as it also implies a squeeze on profit margins.
The dire forecasts of a recession this year being made around Christmas time now appear mis-placed with GDP growth forecast to be around of around 2.5%. Nevertheless, the current cycle is now a decade long, the sugar rush of the Trump tax cuts is wearing off and trade friction and tariffs will have a negative effect. Growth could slow rather unnervingly and apparently three quarters of company chief executive officers expect a recession (two successive quarters of negative growth) by the end of 2020. The data thus far remains mixed. Employment numbers have been resolutely strong for years until the weak February numbers, though one data point is far too early to signal a change in trend.
Jerome Powell, head honcho, at the US Federal Reserve has signalled a major shift in US monetary policy to a far more dovish tone. Indications as recently as December had been that there would be two interest rate rises this year, which contributed to the major sell off in the equity market in the final months of 2018. Powell though has blinked, fearful that the economy may be slowing more than the Fed had expected and that a stock market crash is in no-one’s interest. He has now signalled a move to a ‘neutral’ policy with rate rises on hold and a slowdown in the reduction of the Fed’s balance sheet (by not reinvesting the proceeds of maturing bonds owned by the Fed), a ‘tightening’ process which had been the equivalent of a 1% interest rate hike. Indeed, there is an increasing school of thought that the next interest rate move could be down not up with a cut in interest rates some time in 2020.
Earnings guidance for 2019 has tumbled precipitously over the last few months with the biggest declines in energy, materials and technology. Last year had been a somewhat artificial blowout year, distorted by the Trump tax cuts, with 20% earnings growth. The bar is thus a high one but estimates for 2019 have fallen from near double figures several months ago to a current forecast of barely 4%. More interesting in some ways is the quarterly breakdown of the forecast with an actual fall in earnings growth of 3% in Q1 (the first down quarter since Q2 2016), zero growth in Q2 and the annual figure only really achievable if boosted by a strong 8% recovery in earnings in Q4 (wishful thinking?). Given that the usual direction of travel for earnings forecasts is downwards throughout the year it is possible that the US sees little earnings growth at all in 2019. We are certainly concerned for 2020 with low inflation and rising labour costs hurting margins whilst slowing growth will effect revenues, 2019 may avoid an earnings recession but one looks increasingly likely into 2020.
The equity market rallied strongly last quarter with the S&P rising by 13% for the reasons noted earlier in the newsletter whilst the 10 year bond yield fell sharply to 2.4%. The strong market means that valuations are no longer so supportive with the market trading on forward P/E of 16.5x, which is somewhere around historic averages, making it more vulnerable to negative news flow.
Summary. Markets bounced strongly but a slowing economy, rapidly falling earnings estimates and a relatively rich valuation indicate limited upside for the rest of the year.