MARKET COMMENTARY

2019 Economic and Market Outlook

12.10.2018 - Ronald J. Sanchez, CFA

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The Trek Back to 'Normal' Begins

As we are closing in on the tenth year of the current economic cycle, US equities have returned roughly 400% since the low in March 2009 and have spent the last five years above the prior cycle peak. Recent pro-growth policies have temporarily pushed both economic and earnings growth above their trend rates to what we believe will be cycle peaks. Now, as 2018 comes to a close, a rising chorus of investors is asking the same question, “What’s beyond the peak?”

To answer this question, it helps to keep a few things in perspective. Economic cycles do not have a prescribed length. There are examples of cycles in developed markets lasting in excess of twenty years—more than double the length of this cycle. Additionally, the recent acceleration in economic and earnings growth is mainly attributable to fiscal stimulus.

As the initial benefits wear off, we believe the economy will be able to return to growth near its cycle trend rate. Moreover, there are far fewer imbalances in the economy than there were in the cycle that led to the global financial crisis. Altogether, while we have not yet reached the end of this cycle, we believe the next phase will be marked by moderating market returns and slower economic growth, accompanied by higher volatility as we depart the ideal policy backdrop we have occupied for the last few years.

Forming twin peaks

Ultra-easy monetary policy supported the first part of this cycle, hallmarked by 2% real economic growth. Already accelerating growth, aided by fiscal stimulus enacted this past year, has resulted in an economy that should expand north of 3% in 2018—a likely high-water mark for the cycle. In our view, a moderation of growth closer to 2.5% seems more likely to follow than a significant economic contraction.

With momentum already building, the recent tax cuts provided an additional boost to earnings. Corporations are on pace to grow profits by more than 20% in 2018, which also may be a peak level for the cycle.

But even if economic and earnings growth have peaked, we believe the backdrop that follows will more closely resemble a plateau than a cliff as economic and corporate fundamentals remain on solid footing.

Defining the next phase of the cycle

One statistic often cited by skeptics is the duration of the current US economic cycle—the second-longest expansion since the end of World War II. But in terms of magnitude, it does not come close to the cumulative growth of prior cycles that lasted longer than five years (CHART 1).



This is important to keep in mind when assessing buildups in the economy or markets that produce bubbles, known as imbalances, which tend to take root when the economy is surging. In this period of “lower for longer” growth, however, we see fewer imbalances in the economy and markets that typically bring an abrupt end to the cycle or trigger a recession.

In fact, the economy might be able to grind along, albeit at a slower pace, in part because modest economic growth has kept inflationary pressures at bay. Core CPI continues to hover around the Fed’s 2% target, and wages are growing modestly at 2.9%, well below the 4% threshold that is typically considered the pain point for corporate profit margins. This has allowed the Federal Reserve to take a gradual approach to normalizing monetary policy which has yet to enter restrictive territory.

In the equity market, valuations remain near historical averages, well below the speculative levels seen prior to the tech bubble bursting. This phase represents a departure from the “Goldilocks” environment that propelled markets in 2017, where financial conditions were extraordinarily favorable for equities. We are now shifting into an environment that is merely supportive, but not yet problematic, for equities in the near term.

Perhaps most importantly, imbalances in the economy do not appear to be driven by consumers or corporations. This reduces the risk of a systemic crisis the likes of 2008. Mortgage debt as a percent of gross domestic product (GDP) is more than 20 percentage points below the peak of the housing bubble, and the ratio of total household debt to disposable income is below the peaks of the last two cycles as well as the long-term average (CHART 2). Companies are also in a better position to service their admittedly higher debt. Taking all of these factors into account, we do not presently see any alarming vulnerabilities in the household or corporate sector, though we remain mindful of rising corporate debt levels.
 

Risks that bear watching

Thanks in large part to the record stimulus injected into the economy during the financial crisis, the public debt burden has ballooned to more than 100% of GDP. Other countries have been able to maintain debt burdens well in excess of GDP, but this is a number we will keep a close eye on in 2019 and beyond.

We are also closely monitoring the political climate for any indication that tariffs or trade conflicts are weighing on global supply chains, corporate margins, and ultimately, economic growth. Although the US economy remains on solid footing, there is always the risk of an external event sending shockwaves through the US.

Historically, cycles come to an end when central banks raise rates too aggressively and stifle economic growth. The Federal Reserve does not appear to be at that point, but the risk of a policy error is always present and will increase as we move further along the global normalization path.

Another potential concern is the US housing market. While excessive bullishness led to a housing bubble during the last cycle, the opposite problem appears to be presenting itself today. Housing starts and sales are both sputtering, and affordability concerns loom against a backdrop of rising interest rates.

Staying the course

As we move into this next phase of the cycle, we think investors should moderate their return expectations. As we wrote at the end of last year, we saw room for valuation compression in equities, which we continue to expect going forward. In this environment, stocks can continue to perform well, but are unlikely to deliver the peak double-digit returns and low volatility seen in recent years. This new environment may also produce more dispersion between asset classes and within, which should bode well for active management and stock selection.

While there are countless scenarios that could play out from here to the end of the cycle, we do not believe the end is upon us. The looming risks posed by geopolitical uncertainty and the future path of monetary policy are counterbalanced by a private economy that is far less imbalanced and levered than the last cycle, and market valuations that are in line with historical averages.



This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of December 1, 2018, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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