2019 Economic Strategy and Outlook

 

At the beginning of every new year, the Merit Investment Team takes a look back at the year that was, and looks forward to the year to come, summarizing our findings in this annual “outlook” letter. We are pleased to present to you our 2019 Outlook and Strategy.

 

A Quick Look Back: 2018 Retrospective

Almost all asset classes recorded negative results for 2018, as volatility and uncertainty returned to the markets. However, looking at calendar year 2018 performance does not accurately tell the story. The most recent market rally began in February 2016, providing outsized returns for investors through September 2018. The U.S. stock market rose almost 70% during this two and a half years, and included a 10% correction before setting all-time high levels last September.

After reporting record profit margins and earnings per share during the third quarter, a theme of weakening revenue and profit expectations for 2019 began to emerge in the fourth quarter. Investors began to price in these lower expectations, leading to a 20% decline from the all-time high. Stocks, as measured by the S&P 500 Index, were down 4.4% for 2018, but ended the year with an annualized return of over 13% since February 2016, well above the 10% long-term average rate of return for stocks.

 

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On average, bonds lost ground through most of the year, only to rally during the closing months on hopes the Federal Reserve would not need to hike rates as much as expected in 2019. With a total increase of 1% in the Fed Funds rate during the year, fixed income investments with interest-rate sensitivity were under pressure. The Bloomberg Barclays Aggregate Bond Index was down 1.9% through September, and up the same amount the last 3 months of the year, posting a flat return for 2018.

 

Looking Forward to 2019 and Beyond

While the return of volatility to the stock market has sounded the alarm bells for some, our decision-making looks beyond the day-to day price fluctuations, in search of the long-term opportunities for our clients.

The most recent fall in share prices is actually a welcomed event for those with time and patience. Our team believes there may very well be another round of soft corporate earnings and disappointing global economic news to come, potentially creating a good buying opportunity.

Nobody can predict short-term stock market movements with certainty, and our investment principles keep us from attempting to wander down that dangerous path. However, our process is good at identifying intermediate-term trends and mispricing that can be created by a market correction. Market declines tend to present more opportunities for our team to research and potentially pursue, several of which are listed below.  

 

Transformative Innovation is Upon Us

Our economy and society at large is about to go through a technological transformation with innovations such as 5G wireless technology and the broader use of artificial intelligence (AI). The use of these new technologies will create a large software and hardware cycle that is likely to last several years. Consumers and industry will begin upgrading to 5G cell phones and wireless data networks starting this year, and widespread adoption is expected in 2020.  

With anticipated speeds 20x faster than current cellular service, a much wider breadth of technological products and services can be made available. With our economy at full employment, companies are clamoring for ways to be more productive with their limited human capital. The next several years have the potential to dramatically shift productivity higher across a wide spectrum of industries.

 

 

 

 

 

 

 

One of the most amazing aspects of this story is the relative attractiveness of the high growth stocks, which will participate in this technology cycle. After finding success in growth stocks since 2016, and seeing less than expected downside during the recent market declines, our opinion regarding the attractiveness of growth stocks over traditional value stocks remains the same as it was in 2016. As of this writing, technology companies make up eight of the top 10 stocks in our Core Equity strategy.

Another positive sign for stocks and earnings per share is the level of cash on corporate balance sheets. Companies are likely to boost share buyback programs in the coming months given the lower share prices. While this may not be the best use of capital, it does add to our optimism for earnings per share in 2019.

 

Mixed Signals Abroad

Slowing economic momentum in Europe, uncertainty about Brexit, and trade wars with America have soured our hopes for broad-based international investment gains. While valuations remain attractive, we believe some developed economies have long-term problems, which are likely not solved with ease.

A prime example is the continuing uncertainty coming from the United Kingdom. Trade deals are more difficult to procure than expected, leaving some wondering why an exit from the European Union was desired in the first place. Nothing will be known for sure until at least March, however it appears this will continue to hamper industry from making forward-looking investment plans for the bulk of 2019. Monetary tightening, persistent high unemployment and inconsistent economic growth are making it difficult for outside investors to get excited about equity investments abroad.

A few exceptions to this broad statement concerning international investments would be emerging markets where demographics continue to favor strong economic growth. The vast majority of emerging market economies have slowed over the past several years, along with the global economy, however 1% to 2% higher economic growth (versus the U.S.) is expected long-term. Most compelling are the valuations of most companies in developing nations. Our analysis shows some investments are trading at single-digit price/earnings ratios, a 40% discount (versus the U.S.), which is almost unheard of during the last few years. In addition, downside protection has been seen during the last market correction, a signal investors may have found a price floor in emerging markets.  

 

Rates, Yields, Credit and Inversion

Our team correctly estimated 4 rate hikes of 0.25% from the Federal Reserve in 2018. However, we did not account for the softening language seen from Chairman Powell and others regarding the potential for hikes in 2019. We believe 2 hikes totaling 0.50% is a safe estimate, more than the consensus estimate. The inflation metrics we track give us comfort that destructive levels of inflation in our economy are not around the corner. We estimate steepening wage growth and a tight labor market will begin to affect overall inflation this year, leading the Federal Reserve to hike at least twice.

All of that being said, rates should still be highly accommodative for corporate borrowers, adding to our optimism for earnings growth over the next several years. Given that our economy relies heavily on access to credit, lower rates reduce the expense of funding new projects. There has been some mild liquidity pressure on the lowest quality bonds, however, not enough to raise red flags. As we have stated before, access to credit during this part of the economic cycle is very important, and a key driver for several of our investment themes. We are watching this very closely and stand prepared to make changes, if warranted. 

Much has been said about the inverted U.S. Treasury yield curve. This happens when short maturity bonds have higher rates than long maturity bonds. This inversion indicates investors believe rates will be lower in the future. Historically, an inverted yield curve has signaled an economic slowdown or recession.

 

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Today we have a partially inverted yield curve with 2-year through 7-year bonds yielding slightly lower than the 1-year bond, as can be seen on the chart above. While we do agree the global economy is slowing from the pace set over the past decade, we do not currently see a recession for 2019. Leading indicators remain favorable, and our economy is successfully sustaining full employment. Risk indicators have risen, but not to levels that cause concern. As long as rates remain low, credit markets are stable, and the trade wars end relatively soon, we believe our economy can continue positive growth through the end of the year.

 

Economic Dashboard Update

The most recent market drop is immediately visible on our latest Economic Dashboard. As the price of stocks decline, our valuation measure gets more attractive. Earnings estimates have been reduced, but stock prices have fallen much more in proportion to the earnings declines. This dynamic has our valuation metric looking better than it has over the past 5 years.

Our Financial Stress metrics worsened during the final months of 2018, caused primarily by the interest rate changes previously discussed. Liquidity is a key driver to our success in the future, so this gauge of risk is extremely important to our decision-making. As you can see below, the Financial Stress Index remains towards the top of the chart indicating we continue to operate in a relatively low stress environment.  

 

 

 

 

 

 

 

 

 

 

 

 

 

Conclusion

As our clients know well, we do not spend much time looking backwards. Instead our gaze is constantly looking ahead to the opportunities and risks that are to come. When I have been faced with tough decisions throughout my life, I have learned to seek the advice of friends, family and experts, with whom I trust. Successfully managing your money through the volatility and potential pitfalls is not often successful in isolation. It is for this sole reason that our firm exists. Thank you for your continued trust in our team.

 

Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Merit Financial Group, LLC, an SEC registered investment adviser. Merit Financial Group, LLC and Merit Financial Advisors are separate entities from LPL Financial. 

 

Tracking Number: 1- 808325

 

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

 

There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to effect some of the strategies. Investing involves risks including possible loss of principal.

 

Merit Financial Conditions Dashboard – Footnotes

 

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

 

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The S$P 500 is an unmanaged index which cannot be invested into directly, past performance is no guarantee of future results.

 

Warning- The warning area of the chart indicates the particular measure has fallen below the borderline range of values and may indicate weakness in the U.S. economy and/or additional risk which may need to be considered in their investment decision-making process. See below "Borderline" description for details on how this measure is calculated.

 

Optimal- The optimal reading for all 11 metrics has been determined by Merit Financial Advisors and indicates what they believe to be the best reading possible for a constructive, growing U.S. economy. 

 

Borderline- The borderline reading for all 11 metrics has been determined by Merit Financial Advisors and indicates what they believe to be an indication of possible economic weakness.   

 

Inflation (ECO)- "The Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL) is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods.(1) It can also represent the buying habits of urban consumers. This particular index includes roughly 88 percent of the total population, accounting for wage earners, clerical workers, technical workers, self-employed, short-term workers, unemployed, retirees, and those not in the labor force.(1)

 

The CPIs are based on prices for food, clothing, shelter, and fuels; transportation fares; service fees (e.g., water and sewer service); and sales taxes. Prices are collected monthly from about 4,000 housing units and approximately 26,000 retail establishments across 87 urban areas.(1) To calculate the index, price changes are averaged with weights representing their importance in the spending of the particular group. The index measures price changes (as a percent change) from a predetermined reference date.(1) In addition to the original unadjusted index distributed, the Bureau of Labor Statistics also releases a seasonally adjusted index. The unadjusted series reflects all factors that may influence a change in prices. However, it can be very useful to look at the seasonally adjusted CPI, which removes the effects of seasonal changes, such as weather, school year, production cycles, and holidays. Source: Federal Reserve Bank of St. Louis."

 

GDP (ECO)- Gross domestic product is the inflation adjusted value of the goods and services produced by labor and property located in the United States. Source: Federal Reserve Bank of St. Louis.

 

Unemployment (ECO)- The unemployment rate represents the number of unemployed as a percentage of the labor force. Labor force data are restricted to people 16 years of age and older, who currently reside in 1 of the 50 states or the District of Columbia, who do not reside in institutions (e.g., penal and mental facilities, homes for the aged), and who are not on active duty in the Armed Forces. Source: Federal Reserve Bank of St. Louis.

Jobless Claims (ECO)- U.S. Employment and Training Administration, Initial Claims [ICSA]. Source: Federal Reserve Bank of St. Louis.

 

Labor Mkt Momentum (ECO)- The "KC Fed LMCI - Momentum" is an aggregate index derived from a dynamic factor model that evaluates 24 labor market indicators: Unemployment rate (U3), Broad unemployment rate (U6), Unemployment forecast (Blue Chip), Job flows from U to E, Quits rate, Employment-population ratio, Working part-time for economic reasons, Job leavers, Job availability index (Conference Board), Unemployed 27 or more weeks, Percent of firms with positions not able to fill right now (NFIB), Job losers, Hires rate, Percent of firms planning to increase employment (NFIB), Average hourly earnings, Initial claims, Private nonfarm payroll employment, Aggregate weekly hours, Temporary help employment, Expected job availability (U of Michigan), Labor force participation rate, Manufacturing employment index (ISM), Announced job cuts (Challenger-Gray-Christmas), Expected job availability (Conference Board). More info here: https://www.kansascityfed.org/research/indicatorsdata/lmci Source: Federal Reserve Bank of Kansas City.

 

Leading index for US (ECO)- The leading index for each state predicts the six-month growth rate of the state's coincident index. In addition to the coincident index, the models include other variables that lead the economy: state-level housing permits (1 to 4 units), state initial unemployment insurance claims, delivery times from the Institute for Supply Management (ISM) manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill. Source: Federal Reserve Bank of St. Louis.

 

U.S. Recession Probability (RISK)- Smoothed recession probabilities for the United States are obtained from a dynamic-factor markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales. This model was originally developed in Chauvet, M., "An Economic Characterization of Business Cycle Dynamics with Factor Structure and Regime Switching," International Economic Review, 1998, 39, 969-996. (http://faculty.ucr.edu/~chauvet/ier.pdf) Source: Federal Reserve Bank of St. Louis.

 

Financial Stress Index (RISK)- "Measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together.

 

How to Interpret the Index:

The average value of the index, which begins in late 1993, is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress.

 

More information:

For additional information on the STLFSI and its construction, see “Measuring Financial Market Stress” (https://files.stlouisfed.org/research/publications/es/10/ES1002.pdf) and the related appendix (https://research.stlouisfed.org/datatrends/pdfs/net/NETJan2010Appendix.pdf).

 

For a list of the components that are used to construct the STLFSI see https://www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key. Source: Federal Reserve Bank of St. Louis."

TED Spread (RISK)- Series is calculated as the spread between 3-Month LIBOR based on US dollars and 3-Month Treasury Bill. Source: Federal Reserve Bank of St. Louis.

 

High Yield Defaults (RISK)- High yield default rates provided by J.P. Morgan Global Economic Research. Default rates are defined as the par value percentage of the total market trading at or below 50% of par value and include any Chapter 11 filing, prepackaged filing or missed interest payments. High yield is represented by the J.P. Morgan Domestic High Yield index. Source: J.P. Morgan.

 

Valuations (RISK)- Price to earnings multiple measure using Standard & Poors historical and estimated earnings. The earnings measure is calculated as follows: 50% historical 12-month earnings (equal-weighted between Operating and As Reported earnings), and 50% 12-month forward expected earnings as reported by Standard & Poors. The "x" indicates the calculated multiple, or number of "times", that you are paying for each unit of earnings (Price / Earnings). Source: Standard & Poors.