With economic and political uncertainty manifesting worldwide, 2018 proved to be a tumultuous year for many investors.
As the calendar turns over and we head into a new year, we’re taking a look back at some of the most important factors that helped shape the markets in 2018 — and considering how they could play out in this year. Here are four key dynamics we’re monitoring for 2019.
Corporate Earnings Growth and More Attractive Valuations
Earnings growth for the third (most recently reported) quarter was 26 percent growth year-over-year. That is the highest growth since Q3-2010 and exceeds the prior two quarters’ exceptional 25 percent growth. While we believe the majority of the increase supported by favorable tax cuts has now been realized, the next few quarters are likely to continue to see strong earnings growth, continued. For Q4-2018, earnings are expected to grow at nearly 12.5 percent, which would be the fifth consecutive quarter of double digit earnings growth. Earnings growth projections for 2019 are estimated to be in the mid to high single digits, with all eleven sectors projected to report year-over-year earnings growth.
Strong earnings results combined with the equity market pullback have caused valuations, as represented by the 12-month forward P/E ratio, to dip below the 10-year average (15.78x). The last time valuations were below the 10-year average was early 2016, and the last time they fell below 15x was very briefly in February of 2014. With earnings growth continuing to be strong, these low valuations look attractive.
Flattening Yield Curve
A major theme in the fixed-income markets is the flattening of the U.S. yield curve. The majority of the flattening has been caused by short-term rates moving higher in response to the Federal Reserve’s rate hikes, while longer-term rates have remained fairly range-bound.
While this flattening has been fairly dramatic over the past couple of years, we believe it will slow in 2019 as the Fed slows its rates hikes and longer-term rates move gradually higher from depressed levels.
A partial inversion of the interest rate curve in late 2018 and the prospect for a full inversion — when short-term rates are higher than long-term rates — has added to investor anxiety, because historically that condition has preceded many U.S. recessions. However, our base forecast does not anticipate a full curve inversion, nor do we expect a recession over the next year.
(Still) Rising Rates
The Fed has raised rates nine times since December 2015. Rates are now at 2.5 percent after dropping to effectively zero during the financial crisis period of 2008. Fed policymakers have now indicated they expect to raise rates two times in 2019, compared with a September estimate of three increases. They also have indicated they will keep unwinding their balance sheet.
While the markets are not expecting any interest rate increases in 2019, in contradiction to Fed forecasts, we disagree. The Fed has stated their next moves will be data dependent, and given our expectation for continued economic growth, we believe the Fed forecast is likely.
U.S. Remains Growth Leader
The U.S. has been and should continue to be the growth leader of major developed global economies over the next 12-18 months. Leading economic indicators are still strong, including record levels on the Institute of Supply Management Manufacturing and Non-Manufacturing surveys and strong employment statistics.
Contributing to this strong U.S. leadership position is robust consumer demand, which drives nearly 70 percent of the economy. Consumers are experiencing solid wage growth and plentiful job opportunities with the lowest unemployment levels in nearly 50 years.
Global growth of major developed countries has improved over the past several years but continues to face some headwinds, including political turmoil, central bank uncertainty and more restrictive regulatory environments.
While both the U.S. and other global economies are expected to slow somewhat in 2019, economic momentum should remain solid given the health of the consumer and corporate segments across the globe.