It’s easy to despair when reading dismal economic headlines.
“If it’s not the Fed then it’s trade wars, it’s Brexit, Italy, oil prices—every day there appears to be some overhang that investors become convinced will end the economic cycle,” said Paul Roukis, managing director and portfolio manager at Rothschild Asset Management in New York, during a December 2018 interview.
Investors are also concerned about the two- and 10-year U.S. Treasury spread, which fell to its lowest point in a decade, 0.11%, twice in December. The spread closed at 0.17% on Jan. 3.
“Based on past cycles, [that] would inspire talk of an economic slowdown and a moderation in inflationary pressures,” said Roukis, whose firm manages the Renaissance U.S. Equity Value Fund. Economists have found that when the spread goes negative and the yield curve inverts, a recession usually follows.
Roukis pointed out that in early October, investors were concerned about the exact opposite: rising inflation. “We’ve gone from the concept that the Fed is behind the curve to one where they’ve already tightened too much in just a few short weeks,” he said. “Time will tell if the pendulum swung too far.”
Roukis acknowledged there are two near-term threats to the U.S. equity market, but said both are manageable.
The first is inflation. “After years of accommodative policies by the Fed, interest rates are generally trending higher in the U.S.—notwithstanding recent moves. As we’ve seen, higher rates reintroduce friction into financial markets and the economy.” If the Fed needs to hike beyond market expectations, he says, that would create headwinds.
Fortunately, “the general inflationary backdrop remains benign, which should be good for stocks,” he said. “In a perfect world, measured rate hikes would continue in 2019 supported by strong domestic economic growth trends and controlled inflation.” Since early December, “the Fed seems to be adopting a more flexible approach to its tightening policies,” said Roukis in follow-up comments Jan. 4. He added that as of Friday, “most signs, particularly employment, continue to point to a healthy economic backdrop for 2019. However, there are tangible signs of an economic slowdown in certain overseas markets, which bear watching.”
Investors found out Friday that the U.S. added 312,000 jobs in December, much higher than the average 217,000 per month for all of 2018. Wages rose as well.
The CME FedWatch Tool, which is based on Fed fund futures, shows that a rate pause is most probable for 2019. However, Friday’s positive job numbers led to some traders predicting a hike as early as the May meeting (previously, there was a small probability starting in June).
Roukis’s second threat to U.S. equities is what he calls trade friction. “Trade is interconnected and it’s complex. Supply chains were established over decades, and built on the foundation of comparative advantage. It’s truly difficult to quantify what the impact will be if trade barriers get erected, but a likely consequence could be higher inflation [as] goods would likely cost more to the end consumer.”
Reasons stocks could rise
Corporate profits ultimately drive stock returns, said Roukis. He said 2018 would likely be one of the strongest years on record for profit growth, “with expectations of around 25%. From a historical perspective, this level of growth is unusual from what most investors would assume is the mature part of the cycle.” Such growth is more consistent with the early stages of recovery, he added.
Roukis said that growth “was supported by about 8% revenue growth, improved operating margins, tax reform and capital management, in particular share buybacks.”
As such, he attributed the late 2018 selloff “to a readjustment of 2019 earnings growth expectations. Analyst estimates of profitability have moderated a bit.”
That said, “For the S&P 500 the consensus earnings per share is roughly in the mid-$170s at this point. The assumptions underlying the consensus are not Herculean.”
Going forward, revenue growth assumptions of 5% or so seem reasonable, considering that foreign economies are slowing, the U.S. dollar is strengthening and the U.S. housing market is weakening, said Roukis. Further, “2019 expectations seem to assume very modest or stable operating margin numbers, just given rising input costs related to wages and supply costs. We’ve seen some moderation in pressures in recent months which could help margins in coming quarters relative to expectations.”
A final positive: “Companies have cash. In addition to raising dividends, they’re on target to repurchase over $700 billion in common stock in 2018, and that number likely increases in 2019 barring unusual circumstances.” That could boost EPS by a few percentage points, he said.
As such, Roukis said he’s cautiously optimistic. “We’re entering 2019 with reasonable earnings expectations by investors, with decelerating growth trends appropriately implied in assumptions.”
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