Best Ideas

U.S. to Continue Late-Stage Expansion into 2019

AAM's Take:

As a whole, 2018 made up for 2017’s lack of volatility.

Investors reacted to tax reform, fiery trade discord, mid-term elections, rising interest rates and multiple natural disasters. Not surprisingly, the U.S. equity markets experienced dramatic swings throughout the year, hitting new highs in January 2018 before giving back more than their year-to-date gains by year-end. Emotions can skew investor sentiment, to the point of overlooking economic fundamentals. Which is why, despite the “noise”, we believe that the U.S. will continue its late-stage expansion into 2019. That said, it’s critical to be vigilant in monitoring changing conditions that could potentially propel a recession.

What supports our expectations for continued economic growth in 2019?

the fundamentals:

Although the Federal Reserve’s attempt to balance raising rates with supporting economic growth will be a challenging task, we expect the U.S. economy should be able to absorb the anemic pace of rate increases (relative to previous cycles). Globally, we also expect to see a rebound in both Europe and Emerging Markets believing the new trade agreements with Mexico and Canada are more indicative of the likely resolution to the current trade skirmishes, particularly with China.

Gross Domestic Product (GDP) Improvement

Labor Market Strength

Strong U.S. Consumers and Businesses

Deregulation

Corporate Earnings Growth

History as a Guide

Gross Domestic Product (GDP) Improvement

Labor Market Strength

Strong U.S. Consumers and Businesses

Deregulation

Corporate Earnings Growth

History as a Guide

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1985-1989

1990-1994

1995-1999

2000-2004

2005-2009

2010-2014

2015-2018

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Federal Funds Target Rates

Source: Bloomberg

Gross Domestic Product (GDP) Improvement

The U.S. economy has now added jobs for nearly eight straight years. Continuing jobless claims hit a level not seen since 1970 and average hourly earnings rose to levels not seen since 2009. What’s more, the unemployment rate remained at 3.7% percent in November, the lowest in nearly 50 years.

Labor Market Strength

1990

$20,000 bln

$40,000 bln

$60,000 bln

$80,000 bln

$100,000 bln

Consumer and small business owner sentiment numbers remained high, as has the Conference Board Consumer Confidence Index. We expect U.S. consumer spending will continue to be supported by consumers’ strong balance sheets and income statements—net worth and cash deposits are at all-time high levels and the debt-to-assets ratio has declined dramatically since the 2009 peak.

Household Net Worth and Cash Deposits

Source: Fed Flow of Funds

Strong U.S. Consumers and Businesses

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Current

$4,500 bln

$6,500 bln

$8,500 bln

$10,500 bln

$12,500 bln

Net Worth Outstanding right axis, $100,768 bln

Cash Deposits; $11,657 bln

2.9

2018 Estimated

2.5

2017

1.9

2016

2.0

2015

AAM's Top Themes for 2019

the forecast:

Favor Late-stage Investments

Expect Healthy Rebound in Emerging Markets

Emphasis On Commodity Sector

Expect Pressure on the U.S. Dollar with the Chinese Yuan as the Wild Card

see all 9 of AAm's themes for 2019

Potential Risks to Our 2019 Outlook

the hazards:

Increased inflationary and wage pressures

force the Federal Reserve to be hawkish beyond current market expectations in normalizing monetary policy.

Accelerating consumer debt obligation ratios

beyond past historic stress levels may cause increased defaults and delinquencies.

Shifting political and economic policies

within the European Union move beyond a controlled evolution and fracture several EU economies

Ratcheted tensions between the U.S. and China

spiral to an actual trade war where global growth decelerates and internal price pressures advance.

Earlier-than-expected downgrading of corporate investments

due to increased financial tensions, which prematurely advances the liquidity strains that occur during the end of every cycle.

You and Your Advisor

the relationship:

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Important Disclosures

We expect Emerging Markets (EM) to bounce back, particularly Asia, though still favor some broad-based exposure. We generally favor EM equities rather than debt though select debt may generate strong performance.

We continue to gravitate toward the commodity sector, specifically Energy and Industrial Metals, as these areas tend to perform well during periods of inflation. The pressure that has pushed agricultural commodities lower may have some strong relative outperformance at points in 2019.

Increasing domestic budget deficits and a prolonged global economic recovery will likely pressure the U.S. dollar in the second half of 2019. We see gains in the euro, the pound, and a slight gain in the yen. The wild card is the Chinese yuan, whose direction will likely be determined by how quickly and to what degree trade tensions are resolved.

We’re bullish on late-stage cycle investments with an emphasis on Financials, Energy, Basic Materials, Consumer Discretionary and Industrials.

Deregulation holds the potential to extend what has already been an historic expansion. It generally requires several years of continued deregulation to influence business owners to invest in their business versus meeting increased regulatory requirements. In the four-year period following consistent reduction in regulations, GDP increased to 4.3% annually, well-above the average over the last four decades.

Deregulation

For investors who want more than market fundamentals, we can look to history to better understand our current recovery. While recession lengths before and after the Great Depression were similar in length, the expansions were strikingly different: Expansions prior to the Great Depression—the closest comparison to the Great Recession of 2007-09—lasted only 25 months on average, while the two following lasted 65 months on average.

History as a Guide

Earnings margins in 2018 have improved, albeit partially due to tax reform and the repatriation of U.S. dollars held abroad, both of which served to increase earnings per share (EPS) from a synthetic level. Expectations are for single-digit earnings growth in 2019 given more difficult year-over-year earnings comparisons, however we still expect it to remain above average.

S&P 500 Profit and Operating Margin

Source: Bloomberg, S&P

Historical Average

Profit Margin

Corporate Earnings Growth

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Business cycle reference dates

duration in months

peak

Trough

contraction

Expansion

cycle

August 1918

march 1919

51 67

january 1920

july 1921

28 17

may 1923

july 1924

36 40

october 1926

November 1927

40 41

may 1937

june 1938

63 93

February 1945

october 1945

88 93

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Name

State

Peak to Trough

Previous trough to this Peak

Trough from Previous Trough

Peak from Previous Peak

This commentary is provided for informational purposes only. The indexes referenced in this publication are not available for direct investment. It is not an offer or solicitation of an offer to buy or sell any product or service. Unless otherwise stated, all information and opinions contained in this publication were produced by Advisors Asset Management, Inc. (AAM) and other sources believed by AAM to be accurate and reliable. Due to rapidly changing market conditions and the complexity of investment decisions, supple-mental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are as of December 7, 2018 and are subject to change without notice. All AAM employees, including research associates, receive compensation that is based in part upon the overall performance of the firm. AAM may make a market in or have other financial interests in any given sector or security with which this analysis suggests may be benefited from its conclusions. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Past performance does not guarantee future performance. Chart/Graph Disclosure: The charts/graphs included in this publication do not reflect past or current recommendations made by AAM, “they” should be considered an academic treatment of empirical data and should not be used to predict security prices or market levels. Any suggestion of cause and effect or of the predictability of economic cycles or investment cycles is unintentional. The Best Ideas for 2019 was created using empirical research and analysis by highly experienced market observers and is designed for educational purposes only. This publication should only be considered as a tool in any broker’s, dealer’s or advisor’s investment decision matrix. Investors should consult their financial advisor when applying the assumptions of these charts/graphs.

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Periods Pre- Great Depression

Periods Post- Great Depression

Avg Expansion : 25 Months

Avg Expansion : 65 Months

Operating Margin

Now

6.70%

Historical Average

Now

9.86%

11.64%

13.36%

Annual GDP Growth

Historical Average: 1990-2018

Source: National Bureau Economic Research. Past performance does not guarantee future results.

Source: National Bureau Economic Research. Past performance does not guarantee future results