What Will Shape the Markets in 2019: A Game of 20 Questions, Part II
To the extent one can ask the right questions, the best available answer is often something other than a concrete "yes" or "no." Rather, one has to use ones best judgment based on an assessment of the probabilities. It is in that vein that my posts this month are modeled after 20 Questions, with my best sense of the relevant probabilities provided for the 20 issues I believe are likely to prove the most germane over the course of 2019.
6) Will the US dollar weaken after its strong run in 2018? 55% probability.
Few if any macro forecasts are easy, but over time we’ve found currency forecasts to be the most challenging. In theory, currency strength should be driven primarily by the country’s relative economic growth rate and bond yields. In reality, there are a myriad of factors at work, including a significant role played by traders/speculators, many of whom gravitate to the greenback as a preferred safe haven in times of rising uncertainty. Indeed, to the extent we expect the trade-weighted dollar to decline modestly this year (say 3%-5%, essentially reversing gains seen in 2018), it is largely because futures-based positioning in favor of dollar strength is currently at a three-year high. Merrill Lynch recently termed it the most crowded trade in the market. If we are correct that the Fed remains largely on hold, President Trump could get his seemed wish for a weaker dollar that would aide US exporters, providing at least a modest tailwind for S&P 500 earnings. Importantly, a weaker US dollar would tend to ease the pressure recently placed on emerging markets, particularly China. Equity markets began to recover in 2016 after the so-called (but never publicly confirmed) G20 “Shanghai Accord” that combined Chinese stimulus, a less hawkish Fed and OPEC production cuts to spearhead synchronized global growth. The ongoing US/China trade talks could serve as the basis of a “Shanghai II” type of accord.
7) Will the 2/10 year US Treasury curve invert? 30% probability.
This prediction could be proven wrong very quickly given that the curve is currently less than 20 basis points from inversion. Still, our view is that a near-term peak in the Fed funds rate, combined with resilient (albeit modest) economic growth will allow the curve to gradually steepen over the balance of the year. An important point to keep in mind is that the traditional signaling effect of an inverted curve may be less meaningful than in the past due to the massive bond buying by central banks related to quantitative easing, the hallmark of this unique economic and market cycle.
8) Will S&P 500 earnings exceed the current 8% consensus forecast in 2019? 35% probability.
While 2018 was essentially defined by stellar 20%+ earnings growth (fueled in large part by the one-time impact of the late 2017 corporate tax cut), more than offset by multiple contraction, we expect the opposite trends to prevail in 2019. The market’s 4Q18 sell-off coincided with sharply negative earnings revisions for 2019 due primarily to expected margin compression. The Street has become increasingly concerned that weakening revenue growth due to a slowing global economy and rising input costs (wages in particular) could even result in an “earnings recession” akin to what occurred in late 2014 into early 2016. We do not anticipate a second earnings recession—if nothing else, the prior one was exacerbated by plunging oil prices and crude prices are starting from a much lower base this time around. Moreover, as noted, we expect a somewhat weaker US dollar to provide some support for US multinationals. However, we do expect aggregate earnings growth to be mired in the low to mid-single digits for the year, implying that multiple expansion will be needed for US equities to deliver an above average annual return.
9) Will global and US earnings multiples continue to contract in 2019? 25% probability.
The global one year forward P/E ratio hit a six year low of just under 13x in December, well below the 16x level reached early last year. The sub-13 figure was last seen during the latter portion of the European sovereign debt crisis in 2012. The market clearly does not believe the recent FactSet consensus global earnings growth forecast of about 12% in 2019, which is well above the 6% actual average for the last five years. Of course, further contraction is possible (global P/E's bottomed at about 10x in 2009 and 2011). However, given our view that neither a global nor US recession is likely this year, we expect multiples to stabilize and probably rise over the course of the year. Asian multiples (particularly China) saw the largest reduction in 2018 and probably have the most upside. As for the US where one year forward P/E multiples contracted from about 18x last January to 14x at year-end, we expect modest expansion back toward 15x—the average multiple for the last decade. A key underlying assumption for that normalization is our view that 10-year Treasury rates do not move much past 3% over the course of the year.
10) Will populism cause significant strife in Europe in 2019? 25% probability.
Rising populism is, of course, only one potential risk to the European economy and markets in 2019. After all, it is not as if the continent has been knocking the proverbial cover off the ball for the better part of the 20-year-old Euro-era. While populism in countries such as Italy and more recently France may soon trigger a temporary boost to GDP growth via fiscal stimulus, history says that the boost will be short-lived. The structural barriers to EU growth—from the challenge of navigating monetary union without fiscal union to the tensions between the more prosperous north (Germany in particular) and the less prosperous south—remain formidable impediments to the Union's long-term vitality, if not viability, in our view. While Italy likely warrants particular scrutiny, we see little reason for Europe to veer significantly from its "muddle through" 1%-1.5% or so real GDP growth trajectory in 2019. Importantly, lackluster growth does not imply that European equities are surefire laggards. Most successful European companies are heavily export-oriented. Many trade at seemingly undemanding valuations relative to other developed markets, even when adjusting for the relative dearth of higher growth, higher multiple (read technology) companies.