The process of creating The Ten Surprises begins in the summer when I organize four lunches in the Hamptons for serious investors. About 100 people attend including hedge fund managers, private equity titans and even some academics. One of the benefits of this is that it gives me some clarity on where the consensus is, and that is essential before the Surprises can be determined. The mood at these lunches was clearly positive: the S&P 500 was making good progress; interest rates and inflation remained tame; earnings were strong; the economy was growing near 3%; unemployment was low, but wages were not increasing much; and no recession seemed imminent. Against that background, we still were in a serious trade conflict with China, war in the Middle East continued, the Brexit situation remained unresolved, Chinese growth was clearly slowing and the turbulence in the White House continued with high-level departures and confusing tweets.
The mood changed abruptly toward the end of September, and the outlook darkened. While the United States enjoyed strong growth compared to the rest of the world, investors started to think that economic momentum was shifting toward the negative. Many wondered if the Federal Reserve had been too tight for too long and questioned the policy of raising rates and shrinking the bloated balance sheet. The mid-term elections resulted in the Democrats making major gains in the House of Representatives and that raised the issue of anti-business legislation being passed, with negative implications for equities. Investors began to think there would be a recession in 2019 or 2020, and earnings estimates were being cut by analysts. The market decline erased all of the gains achieved in the S&P 500 in the first eight months and the index was down for the year. The positive consensus of August was entirely reversed.
That was the background as we started to work on the Surprises of 2019. Our view was that the U.S. economy was basically strong and would continue to expand. While earnings increases for the S&P 500 would slow from +20% year-over-year in 2018, they would still increase 5% to 10% in 2019. While many investors were thinking that the stock market decline was predicting a recession, we believed that a recession was several years away. With that basic view, we began to crystallize the final list. We were cognizant of the unpredictability of the situation in Washington. For us to be right on the more positive outlook, a trade deal with China was a necessity and some degree of cooperation between Republicans and Democrats on the budget and immigration was an imperative. There were still many unfilled jobs in departments and agencies. Turnover in the Executive Office had been a record at 65%, more than under any recent president in the first two years and more than George W. Bush experienced in four years.
In the first Surprise, we expect that the Federal Reserve will not raise short-term interest rates during all of 2019. While Chairman Jay Powell was able to assert his independence by raising the federal funds rate a quarter point in December, he is now able to display his sense of reality in 2019. The economy is slowing and inflation and unemployment remain low. Under these conditions, the Fed doesn’t need to raise rates and can stay in that position until conditions change. We further thought that interest rates would not increase much, with the 10-year Treasury yield staying below 3.5%, thereby enabling the yield curve to continue to be positive. With the 10-year yield currently well below 3%, this still provides room for some rise in interest rates if the economy gains momentum.
We don’t think the bull market is over. We view last year’s fourth quarter as a serious and painful correction in what will turn out to be the longest span of market appreciation in the post-war period. That doesn’t mean we won’t experience some disturbing corrections along the way. In the second Surprise, we expect the S&P 500 to be up 15%. Although that sounds like a big move, it would only take the index up to 2875, some 60 points below the high reached in 2018. If earnings for the index are at the consensus level of $170, then the S&P is starting the year at 14.7 times earnings and our target of a 15% rise would put the multiple at about 17 times. These are not levels of excessive valuation. There are many, however, who believe that the economy is faltering and that a weak China and a slowing Europe will cause analysts to lower their earnings estimates. We believe that the U.S. economy will grow at about a 2.5% real rate this year.
For the third Surprise, we thought that the traditional drivers of growth, housing and capital spending, would not be important positives, but that consumer and government spending would be strong. We don’t expect another recession before 2021.
For the fourth Surprise, we expect gold to decline in price. The metal has been in a consolidation pattern for several years and looks like it is going to break out of it one way or another. If interest rates were drifting higher and the equity market were up 15%, then there would be a real cost of owning gold, which provides no return and entails insurance and storage costs. Gold is thought to be an inflation hedge and there is no inflation anywhere. We have gold at $1,000 an ounce for a more than 20% drop. The bulls on gold believe that geopolitical uncertainty plus economic weakness around the world will drive investors toward something that will maintain its value. The number of observers positive on gold seems to be increasing, based on press coverage and the research reports we are receiving. Many analysts continue to be neutral on gold but few are downright negative. A decline to $1,000 would be a big Surprise.
A constructive stance on the emerging markets is our fifth Surprise and, again, the consensus is strongly against this one. The conventional view is that emerging markets produce manufactured goods at low cost and have abundant natural resources, and if the world were slowing, demand for those products would decrease. The dollar is also a factor; emerging markets are hurt by any increased strength of the U.S. currency because many of these countries have dollar-denominated debt and current import obligations that have to be met with dollar payments. We expect the dollar to stabilize at current levels and not be a negative factor in this investment decision. Our positive outlook on the emerging markets is rooted in the view that the middle class in these countries will continue to expand and valuations have become compelling. To be sure, identifying a catalyst that will shift the current profoundly negative sentiment toward this asset class is challenging. Perhaps investors need to realize that the emerging markets will benefit from world growth that is still near 3%. We have the Shanghai composite rising 25% from its currently depressed level and Brazil, under its new conservative leadership, also doing well.
Brexit continues to be unresolved and that is our sixth Surprise. As the situation plays out in our view, British parliament is unable to strike a deal with the European Commission by the March 29th deadline. Theresa May remains Prime Minister, however, by convincing her opponents that a change in leadership wouldn’t solve any of the problems facing the country. Before the Brexit vote in 2016, the United Kingdom was growing at 2%; and now it is only growing at 1%. Realizing that the country is facing an impasse, Britain decides to hold a second referendum. In this one, Britain decides to remain as younger people, for whom an increasing U.K. growth rate means a better job environment, hold sway over the older “nationalists” who dominated the previous vote endorsing leave. Very few of the knowledgeable people with whom we discussed this Surprise agree with our conclusion, but we think this is the only path to resolve the situation.
In the seventh Surprise, we have the Federal Reserve suspending its program of balance sheet reduction, causing the dollar to stabilize. The Federal Reserve balance sheet, which was $1 trillion in 2008, grew to $4.5 trillion at its peak as monetary accommodation kept the economy and the bull market going. The Fed didn’t actually sell many bonds; it just allowed parts of its existing portfolio to mature without replacement. Foreign investors who had been accumulating dollars because the Fed was in a restrictive policy mode pull back. As the U.S. economy slows somewhat, the need for capital from abroad for investment in new plants and equipment subsides as well.
The suspense associated with the Mueller investigation of the Trump presidency and the possible involvement of the Russian government in the 2016 election finally ends with the issuance of a report. In the eighth Surprise, members of Trump’s family and inner circle are implicated but Trump himself is not shown to be directly involved. While there is strong sentiment in a Democratic House to move forward on impeachment, Nancy Pelosi, as Speaker, decides that would be a waste of time because the Senate is Republican. She prefers to focus legislative attention on health care and immigration. The high turnover of White House staff and cabinet positions continues to weigh on confidence in the Presidency, and Trump’s low approval rating dampens investor enthusiasm and becomes a market factor.
Much has been made of the split government with the Republicans controlling the Senate and the Democrats having a majority in the House of Representatives. The assumption is that very little important legislation will be passed. We think that may turn out to be wrong in the ninth Surprise. The Republicans do not want to be viewed in the 2020 election as obstructionists, rejecting bills the voters seem to want passed. They are likely to support an infrastructure program that will help the economy grow at 2.5% or better and deal with the immigration problem in a realistic way. As much as some elements of the Republican Party might like to see a repeal of the Affordable Care Act, they come to realize this is not likely with a Democratic Congress and instead work to make the program more effective in light of the estimated 20 million previously uninsured people it already covers.
Finally, in the tenth Surprise, we take the position that growth rather than value will lead the market. Many technology and biotechnology stocks have come down from the lofty multiples in the recent correction and are now selling at valuations that seem extremely attractive. These include a few of the FAANG stocks. If the U.S. economy were slowing from a pace near 3% to something lower, then downward earnings revisions would be most likely to occur in the cyclically sensitive value sector of the market.
As in past years, we always have a few also-rans that do not make the basic list of ten either because we didn’t believe they had a better than 50% chance of taking place or we didn’t think they were as relevant as the Ten Surprises we chose.
We expect geopolitical tensions to continue in the eleventh Surprise. North Korea does not seem ready to go to war with South Korea, Japan or the United States, but has not taken steps to dismantle its nuclear development facilities. Russia remains a hostile force in the Middle East and Europe. Trump maintains his “America First” policy in international relations and achieves some gains in trade as a result. He also makes progress on national security issues, but the United States fails to be in agreement with the rest of the world on climate change issues.
In Surprise twelve, we say that China continues its monetary and fiscal stimulus programs to maintain growth near 6.5%. In order to do this, however, the debt build-up continues concerning international investors and encouraging Chinese nationals to pull money out of the country. As a result, the renminbi weakens but that helps Chinese exports. Infrastructure investments to modernize the Chinese West and smaller cities continue to be vigorous.
Taking advantage of America’s more inward policy in global affairs, China becomes more global in its focus in the thirteenth Surprise. Building on the Belt and Road infrastructure direct investment program in Asia, Africa and Europe, it announces to the world that it wants to become the leader in free trade. China becomes a leader in the World Trade Organization and establishes bilateral agreements throughout Asia and Europe.
In the last of the also-rans (fourteen), we said that the European Central Bank resumes its accommodative monetary policy to bolster the economies of its members. While the ECB had moved toward a more restrictive policy, it recognizes that the risks imposed by a slowing world economy make an easier monetary policy more sensible in the current environment.
Last year the also-rans did well, so, while the attention is usually greatest on the basic Ten Surprises, giving some thought to those ideas that didn’t quite make the top ten in 2019 is worthwhile.
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