In September, this year looked like it was going to be one of the great years for the Ten Surprises. Oil was at $75 (West Texas Intermediate) and the S&P 500 was at 2,940. The Surprises had oil at $80 and the S&P at 3,000. The Ten Surprises are judged on whether they work out at some point during the year, not where they are at year-end. It looked very likely that oil and the S&P would hit their Surprise targets by the end of year.
Then October happened and both oil and S&P collapsed. The generally favorable conditions for financial markets were suddenly in question. Investors were worried that a trade war was developing between the United States and China. They became concerned that the liquidity, which had been the life blood of the bull market since 2008, was being withdrawn as the Federal Reserve raised interest rates and reduced the size of its balance sheet (by not replacing the bonds that were maturing at a rate of $50 billion a month). Slower growth around the world also worried investors. China, which had been growing at 7% or more, seemed to be struggling to grow at 6%. The market mood shifted from complacent to cautious, and investors sought a catalyst to reawaken the bull. Some wondered if a bear market was beginning; after all, the current bull market began in March 2008 and was more than ten years old.
Assessing the 2018 Surprises against this background, they turned out to be a little better than average. The Surprises are defined as events which an institutional investor would assign a one out of three chance of happening, but which I believe are probable, with a better than 50% likelihood of taking place. Usually I get five or six right, but I compile the Surprises to stretch my (and hopefully your) thinking about the year ahead, and not to get a high score.
In the first Surprise, I said that China would play a role in helping the United States negotiate a denuclearization plan with North Korea. This one did take place, with China withdrawing substantial food and fuel shipments to the country in adherence to prescribed sanctions. China’s involvement was extremely helpful in bringing to the conference table a Kim Jong Unwilling to make some kind of deal. A year ago, we were all worried about a possible military conflict with North Korea. Nobody is talking about that now. There is not a lot of evidence that the country’s nuclear development effort has been dismantled, but the hostile rhetoric has ceased and the prospect of missiles being hurled at South Korea, Japan or the United States seems to have diminished.
For the second Surprise, I thought that populism, tribalism and anarchy would spread around the world and there is certainly plenty of evidence of that. The “yellow vests” riots in France are a good example of anarchy, as protesters with no apparent leaders complain about higher taxes on energy, inequality and the failure of government to improve the lives of the French people. The Brexit impasse, Angela Merkel’s reduced power in Germany and the rise of the Five Star movement in Italy are good examples of the increasing influence of populism. Tribalism is the key cause of Middle East strife. The world has clearly become a more unstable place over the past year.
I thought the dollar would finally come to life and be strong against other major world currencies in the third Surprise and it did. Since a strong dollar can be a problem for emerging markets that have dollar-dominated debt and other obligations in U.S. currency, this was both good and bad news in the financial markets. My reasoning was that interest rates on U.S. Treasurys are higher than for sovereign debt of other major industrialized countries, the United States is growing faster and we have always paid our interest and debt. I had 2018 growth at 3% and it looks like the final number will be at about that level.
I expected a 10% market correction in the fourth Surprise and we got one in February. What I did not expect was that the sharp sell-off at the end of the year would wipe out all of the gains of the first three quarters. My initial reaction to the October decline was that it converted optimistic sentiment to borderline pessimistic and brought the market multiple down from somewhat overvalued to attractively priced. On December 1 over dinner, President Trump and Xi Jinping worked out the framework for a trade agreement that I thought would end the U.S./China Trade War, but confusion about what was actually discussed followed and the markets took another sharp step down. The arrest of the Chief Financial Officer of Huawei increased trade tensions further. The year-end rally that I expected after the mid-term elections never had a chance to gather momentum.
In the fifth Surprise, I saw West Texas Intermediate oil reaching $80 a barrel and it almost got there. In October both Russia and Saudi Arabia increased production and world demand diminished, causing the price to drop to $50. In addition, the assassination of a journalist in the Saudi Arabian embassy in Istanbul created an international human rights uproar and tarnished the stature of Mohammed bin Salman. Another reason the Saudis increased production was to move this incident off the front pages as well as to curry favor with the West. Lower oil prices help keep inflation at modest levels.
I said in the sixth Surprise that inflation would become a concern. While the issue is getting considerable press attention and is actively discussed among portfolio managers, the numbers this year have remained tame with the Consumer Price Index staying below 2%. Average hourly earnings are still around 3%. Because inflation did not erupt as a problem, interest rates did not rise as much as I feared. The Federal Reserve did raise short-term interest rates four times, as I expected in the seventh Surprise. The 10-year Treasury yield moved up to 3.25%, but dropped below 3% amid the equity market selloff and negative speculation about world growth.
I thought in the eighth Surprise that both the Iran agreement and the North American Free Trade Agreement would be modified but would continue. The United States chose to withdraw from the Iran agreement upsetting our European partners. American policy makers were concerned that Iran was not conforming to the requirements of the pact, but the threat of sanctions was the reason that Iran’s nuclear development program was restrained. A revised NAFTA was negotiated, and there have been indications that the administration has been having some second thoughts about not participating in the Trans-Pacific Partnership as China increases its influence throughout Asia.
The Democrats increased their political strength in the mid-term election. They gained 40 seats in the House of Representatives but lost several seats in the Senate. I had the Democrats achieving a majority in both the House and the Senate in the ninth Surprise. To some extent, the November mid-terms were a referendum on the Trump Presidency. The President has begun campaigning for a second term already. At this point his reelection seems probable because of his major accomplishments: tax cuts, regulation dismantling and defusing North Korea. In my opinion, while early, no Democratic candidate has yet emerged who can beat him.
Finally, in the tenth Surprise I expected China to slow down as a result of a policy decision to try to diminish the number of non-performing loans on the books of its banks and shadow banks. As events developed this past year, the Chinese economy slowed more than the government wanted and China implemented a number of measures to keep growth above 6%. These included tax cuts, fiscal and monetary stimulus and infrastructure spending. Because China is a major factor in world growth, its slowdown has added significantly to concerns about the reduced pace of economies across the globe. So far, China has not had a critical influence on the growth of the United States and Europe, but if the trade war escalates, the impact will be felt.
Every year I seek help from many sources in preparing the Surprises. My colleague Joe Zidle played an important role in this year’s Surprises and will be a major collaborator on the Surprises going forward. George Soros reviewed my ideas as he has since they began back in the 1980s. Gideon Rose and Dan Kurtz-Phelan of the Council on Foreign Relations gave me their thoughts on the geopolitical surprises. My Third Thursday group of former research directors provided their annual observations and many friends and associates at Blackstone and elsewhere contributed their ideas. In the end, however, the Surprises are mine and I am accountable for the results. Now on to 2019. I will discuss them in detail in my February essay.
1. The weakening world economy encourages the Federal Reserve to stop raising the federal funds rate during the year. Inflation remains subdued and the 10-year Treasury yield stays below 3.5%. The yield curve remains positive.
2. Partly because of no further rate increases by the Federal Reserve and more attractive valuations as a result of the market decline at the end of 2018, the S&P 500 gains 15% for the year. Rallies and corrections occur but improved earnings enable equities to move higher in a reasonably benign interest rate environment.
3. Traditional drivers of GDP growth, capital spending and housing, make only modest gains in 2019. The expansion continues, however, because of consumer and government spending. A recession before 2021 seems unlikely.
4. The better tone in the financial markets discourages precious metal investors. Gold drops to $1,000 as the equity markets in the United States and elsewhere improve.
5. The profit outlook for emerging markets brightens and investor interest intensifies because the price earnings ratio is attractive compared to developed markets and historical levels. Continuous expansion of the middle class in the emerging markets provides the consumer buying thrust for earnings growth. China leads and the Shanghai composite rises 25%. The Brazil equity market also comes to life under the country’s new conservative leadership.
6. March 29 comes and goes and there is no Brexit deal. Parliament fails to approve one and Theresa May, arguing that a change in leadership won’t help the situation, remains in office. A second referendum is held and the U.K. votes to remain.
7. The dollar stabilizes at year-end 2018 levels and stays there throughout the year. Because of concern about the economy, the Federal Reserve stops shrinking its balance sheet, which is interpreted negatively by currency traders. The flow of foreign capital into United States assets slows because of a softer monetary policy and a lack of need for new capital for business expansion.
8. The Mueller investigation results in indictments against members of the Trump Organization closest to the president but the evidence doesn’t support any direct action against Trump himself. Nevertheless, an exodus of Trump’s most trusted advisors results in a crisis in confidence that the administration has the people and the process to accomplish important goals.
9. Congress, however, with a Democratic majority, gets more done than expected, particularly on trade policy. Progress is made in preserving important parts of the Affordable Care Act and immigration policy. A federal infrastructure program to be implemented in 2020 is announced.
10. Growth stocks continue to provide leadership in the U.S. equity market. Technology and biotech do well as a result of continued strong earnings. Value stocks other than energy-related businesses disappoint because of the slowing economy.
ALSO RANS
Every year there are always a few Surprises that do not make the Ten because either I do not think they are as relevant as those on the basic list or I am not comfortable with the idea that they are “probable.”
11. Geopolitical tensions increase. Iran continues to destabilize the Middle East and Kim Jong Un fails to live up to his North Korea denuclearization promises. Secretary of State Pompeo and National Security Advisor Bolton make statements indicating the United States may take pre-emptive action in both places, thereby causing one of several sharp market sell-offs. But in spite of hostile rhetoric, the United States does not go to war with anyone as we approach the 2020 election. Trump’s tough talk on some issues like trade works, however, and leads to successful diplomatic negotiations on national security.
12. In desperation China engages in ambitious infrastructure programs to bolster its economy. China grows at 6.5% real, but the increased debt causes concern around the world and has a negative impact on the renminbi.
13. China announces, “We want to be the world leaders in free trade.” It sends envoys around the globe to negotiate better bilateral trade terms in order to offset the losses from the ongoing U.S. disagreements. Joint ventures in which foreign companies control the majority share are initiated in all sectors, from industrials and autos to raw materials. As China’s influence around the world becomes greater, the U.S. further isolates itself.
14. The European Central Bank is forced to restart quantitative easing in response to a defiant Italy, a weakening Germany and Brexit. Thwarting expectations that Brexit would bring the rest of Europe closer together, Italy realizes that it can break all fiscal rules without any fear of punishment from the E.U. As a result, the Italian economy falls into recession, debt spreads surge and the ECB is forced to liquefy the system again.
So there they are: The Ten Surprises of 2019. Now let’s see how the year plays out.
This month we made several changes to our “Radical” Asset Allocation. First we cut our recommended weight in Japan to 5% and added that weight to U.S. long only, bringing that weight to 15%. We believe that long only in the U.S. represents a better opportunity in 2019 than Japan. We kept cash at 10%, waiting for further tactical opportunities to develop.
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