Investment Strategy:  First Quarter – Specific Market Reviews: United States

  • Buoyed by the Trump tax cuts the economy expanded by 3.5% in the third quarter last year, the strongest back to back quarterly growth since 2014. Along with the very low unemployment rate of 3.7% this is impacting wage growth with average earnings rising 3.1% y/y, though inflation remains muted with November CPI being just 2.2%.
  • The problem though is that this strong growth already feels like ancient history, certainly to the financial markets which are pricing in a sharp slowdown this year and maybe even a recession as fiscal support fades and monetary policy tightens. The rising budget and trade deficits and the trade war with China also feature highly on the ‘things to worry about’ side of the ledger.
  • Jerome Powell is proving an interesting choice as head honcho of the Federal Reserve Bank, the de facto most important Central Banker in the world. On appointment he was considered to be very much in the Greenspan/Bernanke/Yellen mode, dovish by choice and always willing to underwrite the financial markets with interest rate cuts and torrents of liquidity. This hasn’t proved to be the case with the Fed raising rates four times last year to 2.5% though he is now signalling that interest rates are ‘close to neutral’ with maybe just two rises this year. However, even this relatively dovish tone is worrying markets who are signalling a sharp slowdown in growth and fear that further rate rises will push the US into recession, especially as the Fed is also tightening by no longer re-investing the proceeds of matured bonds it had previously bought as part of QE. Given that the single biggest support for stock markets since the 1987 crash has been Fed policy and liquidity this is something that financial markets will worry and obsess over endlessly.
  • Toxic politics is America’s biggest problem, preventing action on key issues such as immigration and welfare, eroding Americans faith in their own government and its institutions and weakening the image of the US abroad. Trump did not start this debasement but he sure has accelerated it, always seeking to create argument, disharmony and conflict. Following the mid-term elections a divided country now has a divided government with the Democrats taking control of the House of Representatives but the Republicans retaining control of the Senate. The political gridlock increases the likelihood that the economy will slow during 2019 with more focus on the size of the budget deficit, as the partial shutdown of Government services over Christmas has illustrated.
  • Trade policy though remains in the hands of the President and unless a deal is done with China then tariffs will increase significantly from here onwards with adverse consequences for US inflation and corporate profits. The key driver of trade policy will be the extent to which Trump thinks he is inflicting damage but suffering none in return, as I discussed in the main body of the newsletter.
  • Q3 company earnings were another blowout with 25% growth y/y, the best quarter for eight years. Consensus estimates are for 2018 calendar year earnings to have been up around 20%, with less than half of the gain due to lower tax rates. The pace of earnings growth will slow next year, not least because of the adverse effect of the stronger dollar on overseas earnings, and the current estimate is for S&P500 company earnings is 8%. This isn’t too dusty but the problem for markets is the direction of change, and downgrades are currently swamping upgrades. For Q4 2018 for example, earnings expectations at the end of September had been 16.6% but have now fallen to 12.4% according to Factset, the bible in such matters.
  • Wall Street defied gravity for much of last year as other markets stumbled but reality eventually hit in the final quarter as stock prices collapsed, most notably in the tech giants which had led the market charge for the last five years. The worst of the carnage was saved to the very end with Wall Street having its worst December since 1931, falling by 9% having been down 15% at one point. This turned what had been a good year into a negative return of 5%, though the strength of the dollar translated this into a flat return for UK investors. Share price falls in Q4 pulled the market forward P/E valuation back to 15x which doesn’t feel too expensive, though any sense of further earnings disappointment could lead to further market declines.

Summary. Markets sold off heavily last quarter as investors began discounting much slower economic and earnings growth. Expect another volatile year with Trump, trade and monetary policy dominating market sentiment.

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