First Quarter 2019 Forecast and Opinion

2019 is likely to be volatile, but it is unlikely that the U.S. falls into recession. The one thing that could change that is if the partial U.S. government shutdown lasts long enough.

The shutdown is becoming more expensive than the very reason for the shutdown. The U.S. President signed legislation this week promising back pay for Federal workers when the shutdown ends. The problem is that the American taxpayer will then be paying for services which never took place at a rate of $200 million per day, or around $5 billion so far, which equates to the price of the border wall. Economists estimate the partial government shutdown is costing 0.1% of GDP growth to the U.S. every two weeks. We are entering in the fifth week, which will amount to more than a half percent of GDP growth of the entire U.S. If the shutdown lasts for a full quarter.

Short term, the market should continue to rebound to the 2800 level on the S&P 500, because the economy is strong, corporate earnings are still good, stock valuations are attractive, the Fed is moderating its “hawkish” language, and the White House seems to be moderating its stance on trade policy with China. Because of the severity of the selloff in the last quarter, and because of overdone pessimism, it should prove to be more of an “ordinary” pullback.

• Financial conditions, which were very tight in December, are reversing some of that tightness.
• Long bond yields have been declining.
• Short term interest rates are now less likely to rise as much as expected.
• The dollar is easing.
• Credit spreads are narrowing.
• Fears that an unrelenting reduction in the Federal Reserve’s balance sheet are moderating.
• Fund managers drastically reduced stock positions in December, leading to a three year high in cash positions, which is constructive for stocks.
• 2018 saw the fifth largest decline in P/E ratios since WWII. They are now at reasonable levels.

Longer term, the Chinese economy is a worry. China is in the middle of a liquidity trap where the government is providing liquidity in the form of monetary stimulus, but borrowers don’t want it over fears of deteriorating business conditions.
Real estate construction is rising while new home sales are shrinking, creating an inventory buildup which has yet to be absorbed. Factory purchasing manager indices are well under 50, meaning that they are contracting in an economy that is reliant upon manufacturing. As a result, Germany is slowing due to less exports to China as the trade war shifts more globally. In 2018, China’s economy grew at an “official” 6.6%, the lowest in 28 years.

Another worry are the cracks in the façade of the technology sector appearing for differing reasons.
Apple is transitioning from a growth and momentum story to a value story, as there has been a structural shift in the cellphone handset space. The US-China trade war has Chinese consumers boycotting Apple at their government’s encouragement, while Huawei, the global #2 handset manufacturer, is gaining ground. The entire supply chain suffers when Apple suffers, which ripples across the semiconductor sector and impacts the momentum of technology hardware makers.

Further, the financing model of technology companies is changing, which have thrived by issuing bonds through ultra-cheap QE financing. The area of the technology sector fueled by cheap borrowing will face increasing headwinds when financing becomes more expensive, which would be the case with Netflix or Tesla. As for Facebook, it is facing a stagnating number of subscribers as it undergoes continued scrutiny in its role either influencing democratic elections or selling the private data of its users. All of these stocks constitute a disproportionate weighting within the Nasdaq.

The growth rate of US median home prices is at its lowest since 2012. The construction and home building sector is very important to the U.S. economy, and although home prices are still growing at 4.2%, the trend is down. If 30 year bond yields begin rising, as they should later this year due to increased issuance to cover the U.S. tax cuts, housing starts will be impacted negatively. If home prices begin moderating as a result, expect a “wealth effect” to negatively impact consumption.

There are several sectors which look attractive at the moment:

1) Energy

Waivers exempting certain nations that still use Iranian oil from U.S. sanctions will be reevaluated in May. Iran already exports 1.1 million barrels a day less that it did six months ago. Half of Iranian oil exports go to China and India, and it is likely that further Iranian supply will be forced off the market this year. Venezuelan oil production continues to slide, as does Canadian oil production. Russia and Saudi Arabia, which were at peak oil production in November, have both cut back significantly in order to stabilize prices.
OPEC’s oil output fell by 751,000 barrels in December as Saudi Arabia cut production by more than expected. Russia is aiming to accelerate the pace of oil production cuts after pledging to gradually cut its output by 228,000 barrels per day in the first quarter of this year.
The point is that crude oil, which is still down some 30% since its highs in October, is oversold, particularly since it is pricing in a recession as well as additional U.S. supply increases which would outweigh production cuts elsewhere in the world.

There will be an important change in the energy industry in 2019 concerning the imposition of a new, lower polluting diesel fuel oil for ships. Currently, high sulfur marine fuel oil, consumed at 3.5 million barrels per day, is the highest polluting fuel. The International Marine Organization, the international industry body for the shipping industry, is imposing low sulfur marine fuel on all ships worldwide by January 2020.
Ships that don’t comply won’t be insured and won’t be allowed in to ports. The refining industry is not prepared for this, and apparently cannot meet the coming demand. Only one refiner is fully prepared and has made the capital investment in advance to address the increase in demand for this petroleum distillate, and it is Valero Energy. Valero should outpace its competitors based on this.

Valero Energy’s valuation is inexpensive right now. As the following chart demonstrates, its P/E over the past five years has ranged between 6.2 and 19.9. It is now situated at 7.9.


Refiners rely on the spread between input costs and output prices (crack spread), rather than the absolute price of oil.
Valero’s stock is cheap right now for three reasons:
1) The selloff in crude oil last year drove all energy shares lower.
2) The overall selloff in stocks led most stocks lower.
3) The gasoline crack spread is at its lowest in five years, and we are at a seasonal low point. The spread will begin to climb as we approach the end of March and hit peak seasonal demand this summer for gasoline. Furthermore, the diesel crack spread, now at around $26.00, is estimated to climb to above $40 when the new shipping rules come into effect at the end of this year that ban the use of marine diesel with a sulphur content of more than 0.5%. Both of these effects will benefit Valero Energy.

The stock offers a 3.985% yield.

2) Financial

Financial stocks are the most underweight global sector, by far, among fund managers. One of the reasons for this is that the consensus believes that the US Treasury bond yield curve is going to invert.
Banks borrow short term money and lend out longer term, making money on the spread, so that when yield curves “flatten” it impacts profits negatively. The yield curve is almost flat right now; the difference between 2 year yields and 10 year yields is only .19%. Yield curve inversion can be a predictable indicator of coming recessions.

However, with Fed hikes now being priced out, the yield curve is beginning to move in the other direction. The following chart shows the spread between 5 year and 30 year bonds widening, and the banking ETF, in blue, responding to that.


Financials are now the number 2 sector on positive earnings revisions and attractive valuations, and are only beat by the utility sector. They have severely reduced their debt levels, while most corporates are now considered over-leveraged. In fact, no other sector has deleveraged as much as financials over the last ten years:


Banks are now considered value stocks. In terms of both positive earnings momentum and price momentum, J.P Morgan Chase leads the field in the U.S. The stock is cheap relative to its own history, as the following chart indicates, which shows the P/E ratio of JPM over the past ten years:


JPM has a 3.12% dividend yield.

3) Utilities

Utilities are considered defensive and are still cheap based upon fears of rising interest rates which are now less likely to happen. Most utilities are trading near their historical low P/E ratios, and should appreciate roughly 10% in order to rise to their average levels.
This sector is leading all other sectors in terms of positive earnings revisions and attractive valuations.
XLU carries a 3.3% dividend yield.

4) Gold

• When things sour in the financial markets, questions arise over bonds, liquidity and safety.
• The Fed is largely finished increasing interest rates. The prospect of higher rates reduced the attractiveness of gold, but going forward this will no longer be the case.
• The market is worried about re-leveraging. With now higher interest rates, free cash flows may come under pressure, causing eventual credit down grades and “flight” to safe assets.
• The broad trade weighted dollar index is coming down.
• Geopolitical risk can appear at any time, particularly with Russia, China, Saudi Arabia, Brexit, the Donald Trump Presidency (impeachment?), North Korea, etc.

5) Fixed Income

• The Vanguard Short Term Corporate Bond ETF (ticker VCSH) tracks the performance of the Bloomberg Barclays U.S. 1–5 Year Corporate Bond Index. It has an average effective maturity of 2.9 years.
• It offers diversified exposure to the short-term investment-grade U.S. corporate bond market, providing income (3.58%) along with high credit quality and liquidity (it has $25.3 billion in it).
• It has a very low expense ratio at 0.07%

For the full year 2018, the S&P 500 was down 6.23%, the Nasdaq was down 3.9%, and the Dow was down 5.6%.

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