Current Outlook still offers a mix of challenges, opportunities
Within weeks, we will be reviewing 2018 and finalizing our expectations for 2019. So far, this past year has unfolded pretty much as we had anticipated – both economically and regarding the financial markets. Our words of caution regarding “uncertainties” have proven to be correct as we review political developments. Nothing, however, was uncertain about the general direction of stock, bond and alternative strategies. Fueled by higher economic growth and corporate tax cuts, American businesses experienced sharp profit growth and found the ability to return excess cash to investors.
While short-term interest rates rose as expected due to Federal Reserve Board actions, longer-term rates were held down by the comparatively weak yields offered by the rest of the world. Many financial markets were driven by traders playing the “spread game” of borrowing in low-interest rate countries and buying higher-rate U.S. bonds. If those conditions persist and worldwide rates remain low, our bond market will remain unattractive relative to the equity market, and our investment strategies will continue to favor stocks.
We continue to watch closely the shrinking of another “spread” – the difference in yields between U.S. short-term interest rates and U.S. longer-term interest rates. Typically, the wider the “spread” between short and long rates the better the economy can perform, as entities are incentivized to invest for the future. Conversely, the narrower the “spread” the greater the chance that growth slows and the economy recesses. A few years ago, when the Federal Reserve Board was trying to jump-start the economy, they kept short-term rates at near zero while longer term bonds were yielding 1.5 percent to 2 percent. Today 10-year treasury bonds are priced to yield about 3.1 percent while two-year government bond rates have been driven higher by the Federal Reserve Board to almost 2.8 percent. With September’s increase in the short-term Federal Funds rate and expectations of another 0.25 percent increase in December, we could see that “spread” approach zero, increasing the pressure on lenders and investors. We are watching this spread closely and would not be surprised if the Fed halted their rate increases in 2019 until longer-term interest rates world-wide sustainably increase.
One other event we are watching that will impact financial markets is the mid-term Congressional elections in November. Because of the 2016 elections, Washington came under single-party rule for the first time since 2008. As a result, a monumental tax reform package passed that led to a sudden acceleration in corporate profit growth. However, we may experience a return to divided rule after the election. This would give our economy a chance to digest the effects of previous policy changes, but our operating assumption is that we will not experience any roll-back of the tax reforms after the elections. Longer-term issues related to the burgeoning national deficit and debt must be addressed as well. The current path of deficit spending is unsustainable even assuming above-average economic growth. Higher revenue growth and slower spending growth are the only ways to put our fiscal house in order. However, higher taxes and slower spending are also just different sides of the same coin that would place a drag on economic growth.
Thus, our Current Outlook still offers a mix of challenges and opportunities. We expect the rate of profit growth to slow in 2019 to around 8 percent compared to 20-plus percent in 2018. At the same time, equity valuations remain reasonable. Corporate profits have been growing faster than share prices, which means price-to-earnings (P/E) ratios have declined. We expect a broadening of the economy world-wide to produce growth of around 4 percent despite the possible negative impact of trade conflicts. The uncertainty of trade may pose a short-term psychological risk, but we also may see these issues resolved diplomatically, leading ultimately to lower trade barriers. The bottom line: We remain cautiously optimistic and emphasize owning the best companies and fixed-income alternatives to achieve our clients’ long-term return goals.
Richard Pyle is president of the Sanibel Captiva Trust Company. He is also an active investment analyst and portfolio manager for the company and member of the Asset Management Committee.