2019's Potentially Market-Moving Motifs

February 13, 2019

Renown wild man and physicist Richard Feynman said, "Nature uses only the longest threads to weave her patterns, so that each small piece of her fabric reveals the organization of the entire tapestry."
Traditionally woven by hand on a loom, a tapestry comprises innumerable threads that, though individually hidden in the completed work, aggregate to establish whatever pattern or theme the artisan had in mind.
On its own, each thread remains indiscernible. Insignificant. Together, however, these threads convey a bigger picture. Capturing the imagination through its color, complexity, character and creativity. Adding up to a visual narrative that cannot be ignored.

2018 comprised a tapestry of headlines and events. Most of which were insignificant on their own. But combined, they ushered volatility, uncertainty and anxiety back onto the stage. Juxtaposed against 2017's lack thereof. Causing last year to feel fragile. As if one misplaced apple, atop the lot, might upset the entire cart.
Truth is, 2018 was hardly unique. It felt bad. Following 2017's complete lack of volatility. Which always leads people to view markets with a Dire Strait's mentality: money for nothing and chicks for free. Of course, those years are the exception. Never the norm.
Inside the maelstrom, one benefits by perspective. As individual headlines and events rarely become sparks that set the proverbial barn ablaze. Though such storylines begin to integrate. Weaving together, one with the next, to form a tapestry that sets the broader narrative. That tapestry (narrative) capture's the public's attention. Attracting the scant resources of those trepid souls who've neither the time nor energy to dig into the details of each thread. And thus inclined to believe that the narrative is accurate. At which point, the news cycle becomes self-perpetuating. The tail begins to wag the dog. The narrative (i.e., We live in crazy times!) becomes the headline.
At such moments, we must recall the words of Frederick Nietzsche who said, "In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule."
Don't be surprised by the roaring crescendo of the global cacophony. But only by the rare moments of tranquility occurring between its peaks.
Accordingly, we ask: what threads will weave together in the year ahead to form the tapestry (general narrative) from which we can't turn away? That will drive investor behavior? Move The Herd? Among those happenings, to which threads need we pay more attention? And how to separate the wheat from the chaff?
What follows, in no particular order, is some of our analysis on the critical threads we believe should inhabit investor radars in 2019. Some will be critically important to the performance of stock and bond markets. Others will exert an indirect influence that could play a pressing role in the years ahead. Regardless, through these threads you will discern shades of our worldview. The prism through which we make investment decisions. Manage risk. And attempt to provide clients with some peace of mind.
This week's Market Moving Motifs will focus on domestic issues. Next week's on foreign affairs. So without further ado...
Domestic Politics
While the longest shutdown in U.S. history is over, the damage to the economy remains real. And could worsen if the doors close again when the current "continuing resolution" ends mid-February.
Polling reveals the impasse adversely affected approval ratings for Trump, Pelosi, and Schumer. Which Democrats did not anticipate following Trump's misguided pronouncement that he would "own the shutdown."
Social media was not impressed with the performance of either party. As scathing comments abounded over the images of Maxine Waters vacationing in the Bahamas, Pelosi in Hawaii and Steve Mnuchin in Mexico. While non-essential government employees were not able to collect a paycheck. Underscoring the sentiment that growing global discontent with the political class has clearly been lost on them.
Fact is, the average non-partisan American viewed the 35-day shutdown as partisan showmanship, not leadership. Leaving them to ask, who in the nation's capital is representing the average American?
Thus far the economic impact remains murky. But we know of one economic catalyst that appears to have been adversely affected.
Every year, tax-refund season often provides a Christmas in the spring. For U.S. households and the low- to mid-range retailers that serve them. Initial data shows that this spring's Christmas may be postponed.
DataTrek Research observes that last year, the U.S. Treasury issued 99.5 million refunds during the 2018 tax season through April 27, totaling $275.7 billion. Of the 132.6 million households where the IRS processed returns by April 27th, 75 percent received refunds. The average refund amount was $2,771. But this year's data has cooled off.
Either because of the government shutdown or tax filers delaying submissions, the number of returns received by the IRS is down 12.4 percent. And the number of returns processed is down 25.8 percent from the year-ago period. None of which helps consumers, retailers, nor the economy.
Another topic of interest? How about the meteoric rise of freshman Congresswoman Alexandria Ocasio-Cortez (AOC). If you read Conservative websites, she sounds like an ignorant know-it-all. But talk to people her own age, and there is a different view. She articulates concerns younger people have. The very people who represent the nation's future. Some of her ideas are radical, i.e. 70 percent tax rates. Or when she describes her concern for illegal aliens on the southern U.S. border who are, she explains, victims of a rogue U.S. government agency. Not one that is performing its mandate, and enforcing the nation's established immigration.
AOC's concern for the underprivileged, a less unequal society, re-ordering an economy which has squeezed the middle class for decades, these are concerns for man twenty and thirty-year olds. Bernie Sanders' popularity is one sign a change is coming. The fact there are 25+ Democrat presidential candidate possibilities is another. The old guard is moving on. The first post-WW2 generation of leadership is almost gone and the next leadership group, which has gone through an educational system very unlike what most adults did in the 1960s,1970s and 1980s is emerging.
Generation Z, comprising those born from the mid-1990s to the early 2000s, make up 25 percent of the U.S. population. Larger than the Baby Boomers or Millennials. The impact they have on American politics will be dynamic in its duration and affect.
For the president and his party, the mantra remains grow the economy, re-order world trade, strengthen the military and secure cyber-space. Other issues will grab the attention of policy makers in the years ahead. Food security will be a big one. As will be building defenses for a pandemic disease outbreak. Fiscally, the U.S. has a Social Security, pensions and health care problem. But lacks the resolve to tackle them. That will change as the gravity of the situation becomes increasingly apparent.
As form the president's opposition, the focus appears to be on investigating anything having to do with Trump's prospective relationship with the Russians leading up to the 2016 election. Which can be analogized to a four-corner offense towards the end of a basketball game. The goal isn't so much to score, as it is to pass the ball and run down the clock. Leading little time for your opponent to accomplish anything productive as it plays out.
There has been some word that Special Counsel Mueller will soon wrap his investigation. Though we've no clue as to how soon that may occur. Depending on his reported findings, Democrats will either have more fodder with which to conduct an obstructionist agenda (Mueller's findings are materially detrimental to Trump's administration), or have no gunpowder remaining to continue the fight (Mueller's findings essentially absolve Trump's administration of the most callous accusations).
And there remains another school of thought. One that falls within the "be careful what you wish for" camp. It holds that, were Mueller's report to largely be seen as exonerating Trump of any and all claims of Russian collusion, could the general sense of disbelief and irritation by moderate voters, following the colossal amounts of attention paid this storyline the past two years, be enough to propel Trump to a second term? This based on the idea that Trump has been largely positive for the economy ("It's all about the economy, stupid...") coupled with the exasperation of a two-year-plus investigation that ends up with no conclusively nefarious findings. While there remain a million variables to sort out. this would provide the most ironic terminus to this (seemingly) never-ending saga.
U.S. Presidential Politics
Trump? Warren? Biden? Beto? Who knows?
Democrats seem to welcome a new 2020 candidate to the fold every day. Underscoring the party's belief that 2020 will encompass an ABT philosophy (Anyone but Trump).
However, thanks to Trump's victory, one of the ideas inculcated into national electoral thought these last few years has been the idea that the nation is not beholden to career politicians when it comes to its highest office. Polls reveal that much of the nation feels that neither party properly represents them. Further, large swaths of American voters see an increasing need for moderate, centrist leadership. Which explains why hyper-successful business-types like Michael Bloomberg and Howard Schultz have floated trial balloons.
By now, even Trump's most ardent supporters understand the caustic nature of his crass and improvisational communications and leadership practices. Yet, we give credence to the analogy that, in some respects, Trump is to D.C. politics what chemotherapy is to cancer: an often ugly, painful and caustic treatment option that may represent the only means of killing the disease. Because for all his bluster, he has accomplished a few non-partisan victories that will benefit his successor(s), and the nation, for years to come (lowering corporate tax rates; commercial deregulation; focusing on China's virulent trade practices; renegotiating deficient trade agreements).
The nation's two-party system has stagnated in certain regards. Party leadership on both sides has become more interested in winning the weekly news cycle than in broadly beneficial bi-partisan achievements. Democrats keep tacking further left. Republicans have abandoned their fiscal conscience. And neither party seems willing or capable of the type of cross-party leadership that would serve the broader nation. Focused, as they are, on constantly pandering to a handful of special interest groups.
Which is why a prospective White-House bid by Howard Schultz, founder of Starbucks, would be particularly interesting. Like Trump, he has no political background. Unlike Trump (and Bloomberg) he's not trying to win a party nomination. Instead, he'll run independently. Which, for all its vulnerabilities, may lend benefits that did not exist a decade ago.
The nation's non-partisan, middle-of-the-road constituency, which will once again determine the next president, could take an interest in someone who lacks the partisan baggage present in most other candidates. Presented with a thoughtful and accomplished candidate who is unencumbered by partisan baggage, came from nothing, and built a huge, respected, forward-thinking company? Non-ideologues could determine that such an option is exactly what they're seeking, given the mounting exhaustion with both parties revealed in current polling.
Were that case? Then having two consecutive presidential elections won by someone outside of the establishment parties could be a wake-up call for GOP and Democratic leadership. And a catalyst for change in regard to the nation's stagnant political duopoly.
Domestic Economy
Small-business economic confidence slid in January. Reaching its lowest level since President Trump's election. Just 14 percent expect the economy to improve this year. While 36 percent expect it to get worse. "We could be at a turning point," said Richard Curtin, a University of Michigan economist who analyzed the data. "Recessions are not made of one firm collapsing, but of many firms cutting back in marginal ways."
The Labor Department reported superlative jobs data in December and January. Silencing discussion of pending recessions. Pessimists claim jobs are a lagging indicator. But the pace of payroll growth starts declining well before a recession starts. As it did in '89, '01 and '07.
Nonfarm payrolls are up an average of 220,000 in the past twelve months versus a gain of 182,000 per month in the twelve months before that. In other words, we've no sign of the kind of job-creation slowdown that typically precedes a recession. Instead, job creation appears to be accelerating.
While the unemployment rate did rise to 3.9 percent in December from November's 3.7 percent, that can be ascribed to the growth of the labor force -- a healthy +419,000. A slower decline in the unemployment rate combined with faster economic growth signals that potential GDP growth has increased. A likely consequence of lower marginal tax rates and deregulation.
Most positively, workers' wage growth has accelerated. With average hourly earnings +0.4 percent in December. And + 3.2 percent year over year. And that excludes the extra earnings from irregular bonuses and commissions like those paid out after last year's tax cut.
Monetary policy remains loose on a relative basis. And will not be seen as "tight" anytime soon. As companies continue to adapt to lower tax rates, full expensing, and less regulation.
U.S. consumers will be pleasantly surprised with larger-than-anticipated tax refunds. And a trade deal was struck with Mexico and Canada. While negotiations continue with Europe and Japan, which should result in lower tariffs on U.S. exports.
Domestic GDP forecasts have the 2019 U.S. economy growing at roughly 2.5 - 2.6 percent. Lower than last year's growth rate. But still solid. And better than most every other developed global economy. Q1 numbers will be low thanks to the government shutdown. But they should rebound thereafter. The extent of that rebound will be dependent upon how immune the U.S. can remain to many of the issues slowing economic growth overseas.
Economists see the U.S. jobless rate going as low as 3.3 percent this year. Which would be the lowest unemployment since 1953. Providing continuing confidence to the American consumer base. And extending the economic expansion.
Global Economy
The U.S. and China have moved closer to settling their fight over tariffs. But both sides admit to a lot of work needing to be done before any type of deal can be reach. Meanwhile, data on global trade has worsened.
The J.P. Morgan Global Manufacturing Purchasing Managers' Index dropped to 50.7 in January. A reading above 50 indicates growth, but the index is signaling its weakest expansion in 2½ years. The new exports portion of the index was even worse, dropping to its lowest level since May 2016. The index has been a reliable predictor of real global trade volumes published weeks or months after the fact. The weak data could have a knock-on effect for stocks and bonds world-wide. Particularly in trade-sensitive Asian markets.
The difficulty remains China. But negotiations continue. And the U.S. has leverage given the large trade deficit.
Q1 GDP growth will come down from previous projections following the government shutdown. The result of reduced hours worked by government employees, delayed paychecks, and the hit to confidence. The good news? Those numbers should bounce back in Q2 as those headwinds fade.
At some point, the U.S. will have a recession. But little to no data suggesting that a recession will begin anytime in the near future.
Overseas data portends a different picture. As slowing growth in China and Europe, coupled with the inevitable Brexit outcome in March, will continue to affect foreign growth rates. Leaving a lot to ride on U.S. trade discussions with China and Europe. Both of whom hope to avoid any further broadsides to their respective economic outlooks. Investors were jolted last Thursday when the European Commission slashed its growth forecasts for Germany and Italy. And the Bank of England sounded a warning on a slowing global economy.
The brightest stars in the sky could be the emerging market economies. Which comprise 52 percent of the world's population, but only 39 percent of global GDP. A disparity that will quickly shrink in the years ahead. As technology and demographic trends serve to propel huge swaths of these emerging-market populations into the middle class.
The Fed
The Fed reversed course last week. Placing interest rate hikes on hold in response to rising risks to U.S. growth rather than any signs the economy's health has begun to falter. The Fed's new stance is a complete U-turn from six weeks earlier. When it raised rates and penciled in two increases in 2019. What happened? First, when the U.S. economy heated up, inflation didn't take off. Now, inflation risks have diminished. As have the need for additional, pre-emptive rate rises. Second, growth in Europe and China worsened. Third, the Fed's moves to raise rates had started to serve as a drag on confidence.
Dallas Federal Reserve Bank President Robert Kaplan said he believes the U.S. central bank will hold off on rate increases until at least the summer. "It's very important for the Fed to get out of the way" and let uncertainties around the economy resolve themselves, Mr. Kaplan said last week.
Fed officials are calculating how the combined effects of tighter financial conditions and a slowdown in foreign economies could keep a lid on domestic inflation. Even if U.S. economic growth remains solid this year. And when everyone keeps expecting the Fed to pull the punch bowl and turn out the lights? Such flexibility could serve to extend the expansion by bolstering confidence among businesses and consumers.
Gone are the days of QE (quantitative easing). As is the era of fiscal austerity. As that happens, real interest rates will rise. So investors must be cognizant of the amount of capital allocated towards certain types of investments, meaning safety, quality and then growth stocks.
As this regime change evolves, portfolios may need to shift towards international and value. Vacating an ongoing predilection for domestic growth stocks. Which have led for a decade. And will soon be ready for a rest.
Tax Reform
There continues to be a lot of partisan debate as to whether the 2017 tax reform is paying for itself? One year in, we finally have some answers.
Outlets like the Tax Policy Center claim the Tax Cuts and Jobs Act has diminished federal revenue rather than increase it. Other skeptics lament surging government deficits and debt. Some point to last year's brief economic spurt as evidence of the law's failure to drive long-term growth. Even if one accepts these arguments, none of them offers a conclusion about whether the tax cut was worth the cost.
Comparing expected growth in gross domestic product with growth in publicly held federal debt, before and after the tax cut, is a better way to answer that question. As such a comparison captures the long-term impact of tax reform on the economy and the federal budget.
Last week, the non-partisan Congressional Budget Office released a 10-year forecast-the first to assess the effects of tax reform after one year of hard results. Compared with its pre-reform projection, the CBO now expects annual GDP growth to be almost $750 billion higher by 2027, the last year of its prior forecast. A strong case can be made that tax reform played a predominant role in accelerating GDP growth. While most major economies stagnated last year, a sharp rise in business investment in the U.S. helped drive the economy forward.
On the other side of the ledger, the CBO predicts the tax cuts will add $1.9 trillion of additional debt in the coming decade, and that the government will pay about $60 billion more in interest each year as a result.
So the bottom line says an extra $60 billion a year buys the U.S. $750 billion in annual GDP. Which would seem to be a great deal for taxpayers.
Even focusing solely on tax revenue, the government is on pace to collect more than $120 billion each year from that additional $750 billion of GDP. More than enough to cover the additional interest payments. Even if a significant portion of the projected GDP gains since 2017 are not the result of tax reform, the tax cut still pays for itself.
Don't be surprised if Republicans attempt a "middle-class tax cut" sometime this year.
Equity Markets
Massively maligned FANG stocks have enjoyed a roaring 31-percent rally off of their December lows. Credit spreads collapsed. And the Volatility Index (VIX) deflated back to more normal levels. After being rubbed raw through New Years 2018, this is what the soothing balm of Fed liquidity feels like. Ahh, such sweet relief... As global equity investors suddenly surmise a window through which this bull market might yet squeeze. So extending potential stock-market gains before the Market Gods decide the jig is up.
Financial conditions have eased quickly as the dollar weakens. Removing major pressure from the emerging market economies, given their large dollar-funded liabilities. The dollar's rise, fueled by the Fed's hawkishness, was a double-whammy when combined with trade tensions. But if the dollar continues lower and the U.S. and China can find some middle ground? Emerging market equities, having lagged for the better part of the bull market, could really catch fire.
Another sign that markets are pricing in a reversal of fundamental economic fortunes? Nickel just posted its best January in more than 20 years. Capping a 17 percent rise. Portending solid economic tidings as this metal is used in everything from stainless steel appliances to electric vehicles. And if demand continues to send prices higher, it could signal a healthy acceleration in global economic activity.
Still, wrinkles remain.
Sitting at 2710, the S&P 500 index now confronts resistance at its 200-day moving average -- roughly 2750 -- for the fourth time since the Q4 decline began. It must gather the momentum to break through that ceiling of resistance in order to elevate towards last September's all-time high.
Meanwhile, forward earnings expectations are dropping at the fastest pace in three years. Manufacturing activity at home and overseas is slowing. And policy uncertainty remains extremely high on everything from Brexit to China-U.S. trade. Not to mention the specter of another U.S. government shutdown this month. As the debt ceiling approaches in March. S&P 500 companies will likely post their first year-over-year profit declines in nearly three years. And we suspect the consensus may still be overly optimistic. As the health of the U.S. consumer may not blunt the effects of a material slowdown in China and the eurozone.
Yet, such concerns may be kicked down the road. Because despite all the apocalyptic headlines, suddenly the Fed feels like a friend again. And sometimes that's all it takes to reawaken the animal spirits. And embolden investor attitudes for the foreseeable future.
We do believe that emerging market equity markets could represent a real opportunity over the next few years. As U.S. and other developed-market equities look at slowing earnings growth and the tail-end of a decade-long bull market.
Demographic trends and an extended period of uncharacteristic emerging market stock under-performance (compared to U.S. indices) have EM stocks well positioned in the near- and mid-term time frames. Valuations are attractive. And mean reversion (EMs have traditionally outperformed their developed-market peers) likely to reestablish itself.
Gold & Cryptos
Since hitting its bottom in mid-August, gold has quietly rallied more than 6 percent. As of today, it has broken back above its 200-day moving average for the first time since falling below it in early 2018. This is a positive sign... and further evidence that a new rally may be underway.
Unlike crypto-currencies, Gold is a safe-haven investment with real intrinsic value. After the dot-com bubble burst in early 2000, the benchmark S&P 500 Index fell by nearly half. While gold prices rose by 12 percent.
Nor was that an isolated incident. During the 2008 financial crisis, the S&P 500 fell 57 percent. While gold prices rose more than 25 percent. And recently, as the market fell nearly 20 percent from late September to late December, gold prices rose five percent.
Conversely, Bitcoin and rival crypto-currencies have been forced to face their fallibility. After hitting $18,400 per coin in December 2017, Bitcoin prices cratered to $3,300. And with it, the speculative fervor enveloping everything crypto. While we firmly believe that the blockchain technology -- the sophisticated chassis undergirding the entire crypto universe - will yet revolutionize multiple industries and societal trends, Bitcoin and other cryptos may (or may not) be around as the real fun begins.
The author Henry Miller once said, "Confusion is a word we have invented for an order which is not understood." And confusion seems to run rampant where blockchain is concerned. But the real problem is with Bitcoin and cryptocurrencies.
Blockchain is like an engine that can be used in airplanes, vehicles, turbines, elevators, helicopters, escalators, computers, washers and dryers. Bitcoin, however, is like the first Ford Model T car. New and innovated. But I wouldn't want to be tasked with the mechanics.
Next Week
2019's Market-Moving Motifs II will consider the consequential machinations occurring overseas. The regions, technologies, conflicts and trends that will impact the narrative.
Remember, nobody knows exactly what will transpire in the year ahead. But savvy strategists and investors will have a framework through which they view unfolding events. Enabling them to place probability in their favor. While avoiding adverse situations that have the power to change one's trajectory towards financial autonomy.
As the eminent Michael Porter counsels, strategy is about choices. Where one allocates his time and resources. One cannot be all things to all people. Nor can one attempt to accomplish everything along the road to success.
Stay tuned...

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