The process of creating The Ten Surprises begins in the summer when I organize four lunches in the Hamptons for serious investors. About 100 people attend including hedge fund managers, private equity titans and even some academics. One of the benefits of this is that it gives me some clarity on where the consensus is, and that is essential before the Surprises can be determined. The mood at these lunches was clearly positive: the S&P 500 was making good progress; interest rates and inflation remained tame; earnings were strong; the economy was growing near 3%; unemployment was low, but wages were not increasing much; and no recession seemed imminent. Against that background, we still were in a serious trade conflict with China, war in the Middle East continued, the Brexit situation remained unresolved, Chinese growth was clearly slowing and the turbulence in the White House continued with high-level departures and confusing tweets.
The mood changed abruptly toward the end of September, and the outlook darkened. While the United States enjoyed strong growth compared to the rest of the world, investors started to think that economic momentum was shifting toward the negative. Many wondered if the Federal Reserve had been too tight for too long and questioned the policy of raising rates and shrinking the bloated balance sheet. The mid-term elections resulted in the Democrats making major gains in the House of Representatives and that raised the issue of anti-business legislation being passed, with negative implications for equities. Investors began to think there would be a recession in 2019 or 2020, and earnings estimates were being cut by analysts. The market decline erased all of the gains achieved in the S&P 500 in the first eight months and the index was down for the year. The positive consensus of August was entirely reversed.
That was the background as we started to work on the Surprises of 2019. Our view was that the U.S. economy was basically strong and would continue to expand. While earnings increases for the S&P 500 would slow from +20% year-over-year in 2018, they would still increase 5% to 10% in 2019. While many investors were thinking that the stock market decline was predicting a recession, we believed that a recession was several years away. With that basic view, we began to crystallize the final list. We were cognizant of the unpredictability of the situation in Washington. For us to be right on the more positive outlook, a trade deal with China was a necessity and some degree of cooperation between Republicans and Democrats on the budget and immigration was an imperative. There were still many unfilled jobs in departments and agencies. Turnover in the Executive Office had been a record at 65%, more than under any recent president in the first two years and more than George W. Bush experienced in four years.
In the first Surprise, we expect that the Federal Reserve will not raise short-term interest rates during all of 2019. While Chairman Jay Powell was able to assert his independence by raising the federal funds rate a quarter point in December, he is now able to display his sense of reality in 2019. The economy is slowing and inflation and unemployment remain low. Under these conditions, the Fed doesn’t need to raise rates and can stay in that position until conditions change. We further thought that interest rates would not increase much, with the 10-year Treasury yield staying below 3.5%, thereby enabling the yield curve to continue to be positive. With the 10-year yield currently well below 3%, this still provides room for some rise in interest rates if the economy gains momentum.