Economic Forecast: Volatility Returns with Mix of Sunny Periods
A recession isn’t likely to hit in 2019, but investors should be prepared for volatility ahead.
Economic opportunity will remain throughout 2019— but not without a constant threat of turbulence. As we continue through a near record-long period of economic expansion, many analysts and investors are bracing for a recession ahead. However, panelists at a recent Economic Summit sponsored by KeyBank believe that, despite some challenges that are starting to slow the pace of growth, 2019 will be a year of opportunity for investors.
Attendees heard from:
- Joe Calabrese, National Head of Investments, Key Private Bank
- George Mateyo, Chief Investment Officer, Key Private Bank
- Scott Opincar, Member and business restructuring attorney McDonald Hopkins
- Jonathan Ciccotelli, Partner-in-Charge, Tax Services Group, Meaden & Moore.
The panelists opined on how much longer the current economic recovery will continue and what indicators to watch.
The U.S. Economy at the Close of 2018
The reason the panelists remain optimistic about the New Year: the U.S. economy continues to enjoy a period of above-average growth. Unemployment rates remain at record lows. U.S. business conditions are strong, and earnings are growing. Interest rates have been rising but are low relative to prior cycles, with increases helping to normalize the economy. Plus, consumer confidence has rarely been higher. And with the midterm elections behind us, another cloud of uncertainty will pass as well.
The U.S. is experiencing the second-longest expansion on record and is likely to pass the prior record. In fact, most observers do not believe a correction is coming until 2020 or 2021. The Federal Reserve’s October 2018 report gave a 14–16% chance of recession in the next 12 months. The belief is that these strong fundamentals will continue throughout 2019 and sustain additional growth.
Will the Tailwinds of the Tax Cuts & Jobs Act Continue?
The Tax Cuts and Jobs Act passed in December 2017 created favorable conditions for U.S. businesses and investors by reducing the corporate tax rate to 21% and allowing for other business deductions designed to encourage middle-market business growth. However, some Americans believed the new tax code didn’t do enough to boost middle-class families contributing to its relative unpopularity.
According to Ciccotelli, now that the 2018 Midterm Election has concluded, Congress will look at “Tax Reform 2.0,” or propose bills that deal with issues that the Tax Cut and Jobs Act did not fully explicate or that are set to expire.
Taking a broad look at tax reform negotiations, the Democrats, who have taken over leadership of the U.S. House of Representatives, will look at making tax reform more favorable to the middle class. Meanwhile Republicans, who retained control of the Senate, will continue to look to curb provisions of the Affordable Care Act (ACA) and make the corporate tax benefits permanent.
The divided political environment means that any piece of legislation over the next 12 to 24 months will be contentious. The government shutdown that began in December 2018 and extended into 2019 underscores the difficulty of finding compromise. The markets will be somewhat reactive to political change, as evidenced by the “relief rally” following the fairly unsurprising outcome of the midterms and the stock volatility at the end of 2018.
All the panelists cautioned that investors should maintain a cool head regarding pending legislation and not react dramatically to early reform proposals, to media speculation, or tweets from public officials or media. Investors were advised to wait to make portfolio moves until final legislation comes to fruition.
Tariffs, Wage Pressure, Oil Prices, and Other Headwinds
While the economy has been surging, several factors are converging to quell the wave. Chief among them are new tariffs and trade deals implemented by the current administration, which have created uncertainty and volatility in the markets.
The new agreement replacing North American Free Trade Agreement (NAFTA), the U.S., Mexico, and Canada Act, or USMCA, has far-reaching implications, particularly for the automotive industry and its suppliers. The provisions for wages and where component parts must be manufactured will cause auto prices to go up for the consumer. Beginning in 2020, 30% of a car needs to be produced by factories hiring workers at a rate of $16 per hour or more, increasing to 40% in 2023, or be subject to tariffs. That is substantially more than the average autoworker in Mexico earns today. In Mexico, typical wages range from under $4 per hour to $8 per hour. These costs will likely be passed on to the consumer in higher vehicle costs.
Tariffs are already having an impact on the U.S. construction and farming industries. The “Section 232” tariffs are a 25% tariff on foreign steel and a 10% tariff on aluminum, and “Section 301” tariffs on $200 billion of Chinese goods led to retaliatory tariffs on U.S. exports to China, such as soybeans.
While the general perception is that wages are not growing as much they should be in a strong economy, middle-market businesses may be feeling more pressure to raise wages to find and retain labor. Of note, the Bureau of Labor Statistics (BLS) released its monthly jobs report on Friday, November 2,revealing that the U.S. added 250,000 jobs in October. In addition to the strong employment findings, the BLS reports that wages are up 3.14% over the past 12 months, the first time since April 2009 that the metric rose more than 3% from a year earlier.
The energy sector has gone through a readjustment quickly, and crude oil prices have dropped. In the past, lower oil prices provided some tailwind for the economy as lower prices at the pump acted as a tax break for consumers, but more recently investors associate higher oil prices with higher economic growth. However, Mateyo notes that lower oil prices may take some of the pressure off the Federal Reserve to raise interest rates.
Understanding the Yield Curve
One indicator people are watching is the yield curve. Typically, long-term interest rates are higher than shortterm interest rates. If short-term interest rates move higher than long-term rates, the yield curve inverts. An inverted yield curve has foreshadowed a recession before the past six recessions.
One thing to keep in mind is that a fair amount of time passes between when the curve inverts and when a recession initially ensues, and that time is variable. It has been as short as nine months or as long as two years. So, if the yield curve inverts, investors have time to readjust their portfolios.
Lots of Capital Looking for a Home: What’s Next for Investors?
There is an enormous amount of capital in the market, and investors are trying to find a home for it. Mergers and acquisitions (M&A) activity has been booming, and the outlook is positive for 2019. Opincar notes that the readycapital from traditional banks and nontraditional financers is the top driver of activity. He also points out that the amount of capital in the marketplace, coupled with loosening of federal regulations, has resulted in covenantlite loans.
Additionally, Opincar sees private equity taking a longerterm approach to acquisitions, planning to hold assets for seven to ten years, rather than acquiring, restructuring, and selling in three to five years.
In 2019, expect to see heightened M&A activity in the automotive, energy, healthcare, and consumer products sectors. This includes distressed assets or underperforming companies looking to get refinanced and prove themselves.
Another option for investors is alternative investments. One element of the Tax Cuts & Jobs Act that is still taking shape is the creation of the Opportunity Zones program, which aims to incentivize private investment in economically distressed communities. Investors can receive incremental tax exclusions on capital gains by investing in a qualified opportunity fund and holding the investment for 5, 7, or 10 or more years.
Managing the Return of Volatility in the Markets
Though 2019 should be another year of growth, investors should be prepared for volatility. The full impact of factors, including political division and tax reform, slowing global growth, rising wages and interest rates, and tariff negotiations is yet to be realized. Investors should have a well-diversified portfolio that remains somewhat overweighted in growth assets. A trusted advisor can help you build, manage, and protect your wealth. Key Private Bank understands the needs of wealthy individuals and can help you make decisions that support your goals.
For questions, please contact your KeyBank Commercial Bank Relationship Manager.