by Bill O’Grady & Mark Keller |PDF

Summary:

1. Economy grows at 2.7%.
2. Expansion makes a new duration record; no recession expected in 2019, although the risk of a downturn will be increasing.
3. Core inflation max is 2.5% next year.
4. Dollar weakens, although the direction is mostly dependent on administration trade policy. We expect preparations for the 2020 elections will lead to a less aggressive trade policy compared to 2018.
5. S&P earnings for 2019 will be $160.93 on an S&P basis (6.25% of GDP); using the Thomson/Reuters methodology, the reading would be $171.20.
6. Assuming a P/E of 18.6x, using the S&P earnings projection, our expectation for the S&P is 2994.04.
   a. The key to this forecast will be the P/E.
   b. The multiple has been weakening on trade fears.
7. If we underestimate the S&P next year, it will likely be due to the election cycle; the year before the election tends to be most favorable, with the usual gain up 16%.
8. Mid-caps are unusually cheap and would be most favored. Small caps have also suffered recently and are favored as well, although less than mid-caps.
9. Growth has greatly outperformed value, a trend that has been mostly driven by multiple expansion. If the multiple stabilizes as we expect, value should be equally weighted.
10. International is favored on our assumption that the dollar weakens.
11. Our terminal expectation for fed funds is 3.00% to 3.25%.
12. We expect the 10-year yield to peak at 3.25% next year.
13. Investment grade bond spreads should stabilize; high yield bonds are overvalued and should be underweighted.
14. Commodities should do better next year if our dollar forecast is correct.

Risks to the Forecast:

1. 1. Primary risk: Fed policy mistake. The Fed raises rates in excess of our expectation and triggers a recession.
   2. Italy brings down the Eurozone. Italy refuses to control its deficits, leading to a financial crisis in the Eurozone.
   3. Trade war with China. In reaction to continued tariff pressure, the PBOC pushes the CNY lower, which triggers capital flight and a debt crisis in China, bringing a global downturn.
   4. Inflation expectations become unanchored. Although the least likely of the risks, it would be the most devastating, leading to higher interest rates, falling P/Es and a weaker dollar. If the Fed remains independent, cash would become the best performing asset class. If the Fed’s independence is undermined, gold, real estate and commodities will have the best performance. We do expect this event to occur somewhere in the next 10-20 years.

Although our base case calls for no recession, moderate inflation and continued modest gains in equities, there are growing risks of recession. We will detail the four “known/unknowns” near the conclusion of this report.

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