By the end of the summer I became convinced that the United States equity market was setting itself up for a powerful post mid-term election rally. The economic fundamentals were strong: unemployment was at a 40-year low and real growth was better than 3%; the Federal Reserve was raising rates, but that was only a noble attempt to creep back to normal levels for the later stages of a business cycle. The yield curve was likely to remain positive, inventories were not excessive and leading indicators were still rising.
Offsetting these positives was market valuation. My model indicated equities were fully priced and sentiment indicators suggested that investors were dangerously optimistic, emboldened by the favorable fundamentals above. The Fed was shrinking its balance sheet and slowly draining the economy of liquidity, the lifeblood of rising equity markets. There were signs that the economy was decelerating. Earnings increases were slowing from a rate of 20% year-over-year in 2018 driven by the tax cut to an estimated 10% year-over-year in 2019. Two traditional drivers of growth, housing and capital spending, had yet to gather momentum, leaving the work of expanding the economy to the consumer and government spending. There were a number of aspects of the Trump administration’s policy agenda, like healthcare and immigration, that were unsettling to investors. In addition, the United States was in conflict with China over tariffs and trade policy.
There were also problems emanating from abroad. China, which had orchestrated a modest slowdown at the beginning of the year to try to reduce the non-performing loans on the books of its banks and shadow banks, had slowed down more than expected and, in response, policy makers had to cut taxes, depreciate the currency, step up fiscal spending and engage in monetary accommodation. European growth had been negatively impacted by Brexit. The rise of populism in Europe had weakened Angela Merkel’s leadership in Germany and boosted authoritarian rule in Eastern Europe. Military conflicts continued in Syria, Yemen and throughout the Middle East. These issues all have an indirect impact on the economic stability of the United States.
For these reasons I thought the equity market would have to go through a correction to improve valuation and sentiment. In October, the sharp decline in the market wiped out all of the gains in the indexes from the beginning of the year. Major investment advisors changed their view of the outlook from positive to negative. Sentiment moved into pessimistic territory. The S&P 500® is only selling at 15.6 times 2019 projected earnings. Conditions became favorable for the year-end rally I had been expecting.
Then the mid-term elections took place. There was nothing really surprising in the outcome. The Democrats seized control of the House of Representatives and the Republicans gained some seats in the Senate. The significance of the shift in Congress can be debated. I expect to see the President begin campaigning for a second term immediately. I also believe it will be hard to get major legislation enacted, but there may be some adjustments made in the tax code and the Affordable Care Act. Both sides recognize the need for improving our infrastructure, but little progress has been made on this front so far in spite of talk of a trillion-dollar program. With the annual budget deficit increasing from $800 billion to $1 trillion because of the tax cut and spending programs already in place, there might not be much enthusiasm among either party for expanding the deficit further.