Poised for a 2018 Year-end Rally

The U.S. Stock market has been in a sideways trading range since the January 26th market high. Following great performance in 2017, the stock market was overdue for a period of digestion and consolidation. The questions are: When will the market break out of the trading range? And will we see a new high or new low by the end of the year? The direction is likely to be based on the path of several political issues: trade negotiations, the mid-term elections, and the Mueller investigations. We believe that the odds favor an upside breakout coincident with the mid-term elections leading to positive 4Q performance.

Figure 1 – The S&P 500 has been Range Bound Since January 26th

S&P 500 Stock Chart 2016 - 2018

The U.S. economy is in great shape

The Fed minutes came out Wednesday and showed that they believe the economy is strong and that future inflation will stay contained.  In our estimation, growth will be near or slightly above 4% in the second quarter and is likely to exceed 3% for the rest of the year. S&P second quarter earnings growth is likely to exceed 20% and reach $160 per share for the year. We also see further earnings improvement in 2019, but the degree depends on trade and consumer/business confidence. A recession is nowhere in sight. 

Trade Wars were started by the U.S. and can be Ended by the U.S.

President Trump’s negotiating tactics are to make outrageous demands with bravado but then to pivot or back down into some sort of victory. My guess is that the conflicts with Europe, Canada and Mexico are likely to be at least partially resolved a month or two before the mid-term elections. Like North Korea, any trade successes will be claimed as victories, and designed to boost the Republicans in the elections.  

China is a more complex issue as we want to influence their long-term plans to be dominant in technology by protecting our intellectual property. We were not surprised that North Korea is now raising some red flags in the negotiation of denuclearizing the Korean Peninsula. China has its fingerprints are all over this setback and is playing their North Korean card in its trade discussions with Trump.  Remember that Trump wants to win the Nobel Peace Prize.

Opportunities in International Markets

We fully expect growth in the ECB and Japan to improve as we move through the rest of the year and into 2019 after a rough patch caused by a very strong euro and yen until recently. Here again, we are watching trade negotiations closely as both economies are overly dependent on exports for growth. Clearly the BOJ and ECB are on hold maintaining overly easy monetary policies.  If the trade disputes abate, European stock markets should be off to the races.

The U.S. Stock Market will Anticipate the Mid-Term Elections

We believe that President Trump measures his performance by the financial markets and his end game is higher stock prices. The stock market would behave best if the Republicans maintain both houses.  Current oddsmakers call the House race a toss-up and the Senate remaining under the control of the Republicans. A Democratic House and Republican Senate would be considered political gridlock but not deemed bad for the financial markets. My best guess is that with Trump controlling the trade and economic agenda, there will be several positive political and economic surprises before November 6th. 

Interest Rates Have Turned Higher

As the economy improves and the tax cuts kick in, interest rates should tend to go higher. When Europe starts to unwind its Quantitative Easing, global interest rates should go higher. If inflation continues to pick up, interest rates should go higher.  As U.S. Treasury debt issuance doubles over the next two years, interest rates should go higher. The Federal Reserve knows these things and plans to raise interest rates by an additional .50 percent this year and 1% next year, in 0.25% increments.   

Washington and the public have forgotten that deficits matter. Between 2017 and 2020 the Federal deficit is expected to double from $650 billion to $1.15 trillion, over 5% of GDP.  As interest rates rise, government borrowing costs will rise accordingly.  If the economy hits a slow patch, there will be limited room for fiscal stimulus. Debt issuance will likely become the Achilles heel of the economic recovery.

While interest rates are not likely to jump up overnight, we expect that 10-year U.S. Treasury interest rates will increase from 3% to 4% in 2019 and 5% by 2020.  Two-year bond rates should match or exceed these increases.  In this scenario, mortgage loans may approach 5% in 2019 and 6% in 2020, potentially stifling real estate growth.  Once a bear market in bonds starts, it cannot be easily stopped. The era of cheap money is over!

Figure 2 – Interest Rates are on the Verge of a Major Breakout to Higher Levels

U.S. Treasury 10 yr. Yield 1994 - 2018

Investment Themes for 2018

While the markets have been erratic and volatile, we remain fully invested according to client’s targeted equity allocations. In fixed income, we have shortened bond maturities and increased bond quality, often by adding short maturity U.S. Treasury bills and notes.   

The equity markets appear to be at a crossroads.  Either the positive fundamental outlook needs to reassert itself, most likely driven by earnings out performance, or a bear market will take hold. The bullish case should be driven by robust earnings growth, coupled with benign inflation and increased capital spending plans.  The bearish case is premised on overly high market valuation, trade war concerns, and chatter about political paralysis. We are biased towards the bullish outcome. 

While we remain hopeful that the earnings season will exceed expectations and drive the markets higher, we are taking a wait and see approach to aggressive equity allocations.  As we are believers in higher interest rates over the next two years, our favorite equity sector is financial stocks.  Emerging markets continue to remain interesting on a value basis as they continue to have the demographics for future growth opportunities.  Overall, we are bullish on equities and bearish on bonds.