Delayed by the partial government shutdown that began shortly before Christmas, and then swiftly overtaken by the frenetic pace of events of a turbulent 2019, the fourth quarter economic report offered a hazy picture, with uncertainty being all that seemed to be certain. So far in 2019, the United States economy remains generally solid, but the effects of the 2018 tax cuts are fading, and earnings growth is expected to slow. The tax cuts may have boosted corporate earnings, but they have also increased federal debt levels.
Gross domestic product (GDP) grew at an annualized rate of 2.2% in the fourth quarter of 2018, down from 3.4% in the third quarter and 4.2% in the second quarter. The economy grew overall at a pace of 2.9% in 2018, an increase from 2.2% in 2017 and matching 2015 growth as the biggest increase since the end of the recession of 2007-09. The record five-week partial government shutdown, which ended on Jan. 25, had an effect that possibly cost the economy 0.1 percentage point of growth in the fourth quarter, according to the Bureau of Economic Analysis. Economists expect this effect to continue slowing growth in the first quarter of 2019.
The recent market gains in 2019 stand in contrast with the economic data indicating a slowdown and the mixed signals this data is showing. For example, the final revision for the fourth quarter GDP brought the number down to 2.2% from originally reported 2.6% because of softer consumer spending and a weaker climate for business investment than originally reported. A second example is a December report delayed by the partial government shutdown showing that construction spending declined 0.6 percent after an unrevised 0.8% increase in November, contradicting a Reuters poll of economists forecasting a 0.2% rise in December. While it rose 4.1% in 2018, that year’s numbers were was the weakest reading since 2011.
The construction spending report extended the run of weak December economic data that has included retail sales, housing starts, trade, and home sales into the first quarter. The data on household spending remains tepid and retail sales fell in February. The Institute for Supply Management’s Manufacturing Index is still pointing to solid growth, but its average for the first quarter is well off the fourth quarter’s level which tells us that growth is slowing. The report from the Commerce Department after the fourth-quarter GDP was released on March 25 provided further evidence that the economy had lost momentum at the tail end of 2018. Growth is slowing as the stimulus from a $1.5 trillion tax cut and increased government spending ebbs. Trade tensions between the United States and China, as well as slowing global economies, also hurt domestic activity.
Still, at least some of the gains seen over the first two months of 2019 can be attributed to positive reports regarding the U.S.-China trade dispute. These reports culminated with an extension of the deadline for a deal to be completed before the U.S. raises tariffs on imported Chinese goods. If no deal is struck and tariffs are imposed, Bowen Asset Management believes that there is likely to be more market downside than there would be upside opportunity if a deal was made.
Weakness in residential fixed investment, which fell 3.1%, and in state and local government spending served as a drag on the economy in the fourth quarter. The gross private domestic investment gain slowed to 4.6% in the fourth quarter after a robust 15.2% rise in the previous period.
Fourth-quarter growth was helped, however, by a 2.5% rise in consumer spending, along with increased nonresidential fixed investment, exports, private inventory investment, and federal government spending. Consumers spent more on new cars and trucks, health care, and financial help. Households may not have spent as much as they did in previous quarters, but it was more than enough to keep the economy on a steady keel. Exports rose 2.8% in the quarter, reversing a 4.9% decline in the previous quarter, while imports increased by 2.0%, making trade a slight net negative overall.
One positive development that has the potential to counteract the slowdown is the clearly dovish turn by the Federal Reserve, which had been expected to make two rate hikes in 2019 and yet another in 2020. Minutes from the January meeting of the agency’s Federal Open Market Committee — which sets monetary policy, including the interest rates that are charged to banks — indicated awareness of the slowdown while not feeling pressure from rising inflation. At the Federal Reserve’s March meeting, the Fed did not change its benchmark rate from the current level of 2.25–2.50%. However, the Fed’s “dot plot,” a chart that shows where each member of the Federal Open Market Committee believes the federal funds rate target should be at the end of each year, indicated that the rate will remain unchanged in 2019 and only increase once in 2020, bringing the rate to a 2.5–2.75% range at the peak of this cycle.
At the same time, the updated summary of economic projections indicates that the Fed has downgraded its assessment of the economy’s growth rate over the next few years. Growth estimates for GDP were reduced to 2.1% in 2019 from a previous estimate of 2.3%. Similar reductions were made for 2020 GDP growth estimates. Recent forecasts for the first quarter of 2019 from the Fed range between 1.3-2.1%.
Other recent conflicting data released shows that U.S. industrial production rose by 0.1% in February, below the 0.4% increase expected by economists. January’s figure, however, was revised to show a 0.4% drop, rather than a 0.6% decline as previously estimated. The report also showed capacity utilization, the percentage of resources used by firms to produce goods, falling slightly to 78.2% in February, down from 78.3% in January. The capacity utilization rate showed that business fixed investment in the fourth quarter was concentrated in buying equipment and product research, offsetting declines in spending on buildings.
At the Fed’s December meeting, the unemployment-rate estimate was projected to move to 3.7% in 2019, up from a previous estimate of 3.5%. Employment had been strong until February numbers were released. U.S. nonfarm payrolls added just 20,000 jobs in February, well below consensus and the smallest monthly gain since September 2017 when just 16,000 jobs were created, reflecting the impact of hurricanes Harvey and Irma. After revisions, the average gains for December, January, and February are 186,000. The official jobless rate fell to 3.8% from 4%. The report showed signs that companies are paying up for employees in a tight market. Wages, however, which are the largest portion of corporate costs, are rising at the fastest pace in a decade. Average hourly earnings for private workers rose 0.4 percent from the prior month, topping estimates, following a 0.1 percent gain.
Slowing U.S. economic growth could likely pressure top-line corporate revenues, while a sharp slowdown in global growth as well as rising U.S. labor costs also pose a risk for earnings recession this year. A recession could cause the world’s central banks to take steps to ease monetary policy. Analysts have been lowering their 2019 earnings forecasts over the past few quarters. The cuts have been tied to the 2018 oil-price collapse, the effect of the “roll-off” in the corporate tax cuts’ impact on year-over-year earnings growth, and slower global growth.
Meanwhile, strong 2018 earnings growth won’t be repeated in 2019, partly because last year’s earnings set such a high bar; after rising more than 20% in 2018, year-over-year S&P 500 index earnings growth is expected to be negative in the first quarter, and to grow by single digits in the remaining quarters of 2019.
Bowen Asset Management is not expecting a recession in 2019; however, we are not currently seeing the prospect of any dramatic economic growth either. The second quarter is likely to tell the story of this year’s economy. Weather is starting to warm somewhere and confidence is improving. If we don’t get a solid rebound in growth in the spring, especially after what is likely to have been a very disappointing first quarter, then it is hard to see how the economy will have anything but muted performance going forward. There is nothing out there to push growth forward and the comparisons with the tax cut-hyped 2018 economy is going to make things more difficult. That points to lackluster market performance with outperformance driven by a few selective areas. Investor sentiment is likely to swing wildly in 2019.
Disclaimer
While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.
Past performance should not be taken as an indicator or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. As with any investment strategy or portion thereof, there is potential for profit as well as the possibility of loss. The price, value of and income from investments mentioned in this report (if any) can fall as well as rise. To the extent that any financial projections are contained herein, such projections are dependent on the occurrence of future events, which cannot be predicted or assumed; therefore, the actual results achieved during the projection period, if applicable, may vary materially from the projections.