Reasons stocks are falling, and why they could rise.
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Paul Roukis, portfolio manager of the large cap value strategy at Rothschild.
The catalysts for further downside in U.S. equities change by the day, or some may call it the headline of the day. 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, and not only the economic cycle but the bull market.
Take interest rates, for example. In early October the main concerns were rising inflation and interest rates, following Fed chairman Powell’s remarks about current rates being below the yet-to-be-quantified neutral rate range. Today investors are concerned about the polar opposite, as the yield curve, and that’s measured by the two- to 10-year treasury spread, has narrowed to near zero. Which, based on past cycles, would inspire talk of an economic slowdown and a moderation in inflationary pressures.
So, think about this. 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. So no doubt the world is dynamic, but maybe it’s not that dynamic. So time will tell if the pendulum swung too far. Notwithstanding a recent downshift in growth and inflation expectations, one of the biggest near-term threats to the U.S. equity market, and asset prices in general, remains inflation in my view.
After years of accommodative policies by the Fed, interest rates are generally trending higher in the U.S. Again, notwithstanding recent moves. And as we’ve seen, higher rates reintroduce friction into financial markets and the economy. If the Fed finds itself behind the curve and rate hikes are needed beyond market expectations, and here I’d stress market expectations, this scenario would likely prove to be a headwind to the markets.
With that said, the general inflationary backdrop remains benign, which should be good for stocks. And not only benign, but we’ve seen some moderation recently. In a perfect world, and I recognize that backdrop doesn’t usually exist, but in a perfect world measured rate hikes would continue in 2019 supported by strong domestic economic growth trends and controlled inflation.
An equally important near-term concern is trade friction, which seems to be on the front and centre of everyone’s minds at this point. 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. At the end of the day, goods would likely cost more to the end consumer. Finding the right balance is a priority among all the major trading partners at this point, but the reality is there will always be perceived asymmetrical barriers that make trade a complex subject to deal with.
As investors it’s important to understand the risks as they relate to individual companies. But unfortunately it’s very difficult to quantify those effects.
You know, the question of what are the catalysts to drive stocks higher to me would include [the fact that] investor sentiment needs to regain its footing after the back and forth we’ve seen in recent months. That would probably need to originate through incremental positive underlying data points, reinforcing to investors that the economy is not headed for a recession in 2019. At least to this point most signs continue to point to a healthy economic backdrop.
The second major catalyst could be corporate profitability above market expectations. In my view corporate profits are ultimately what drive stock returns. And here I’d like to set the narrative, it’s best to begin with the starting point, and that is the 2018 corporate profit trends. 2018 is shaping up to be one of the strongest years on record for profit growth, with expectations of around 25%. So from a historical perspective this level of growth is unusual from what most investors would assume is the mature part of the cycle.
Normally, growth of this magnitude would be much more consistent with what you see in the early stages of recovery. And I would say with the growth in 2018 it was balanced. It was supported by about 8% revenue growth, improved operating margins, tax reform, and capital management, in particular share buybacks. So when you think about the equity selloff in the final months of 2018 we think one of the primary reasons was likely attributed to a readjustment of 2019 earnings growth expectations.
Analyst estimates of profitability have moderated a bit from that, call it 8% to 9% range to about 7%. You know, for the S&P 500 the consensus earnings per share is roughly in the mid 170s at this point. To me the assumptions underlying the consensus are not herculean. Revenue growth assumptions of, say, 5% or so seem reasonable, and take into account a lot of that backdrop uncertainty that we’ve seen: slowing foreign economies, a stronger dollar, among other things, like the weakening U.S. housing market.
On the margin side companies usually benefit from economies of scale and productivity enhancements over time, but 2019 expectations seem to assume very modest or stable operating margin numbers, just given rising input costs related to wages and supply costs. And just a note here, as it relates to these line item expenses, we’ve seen some moderation in pressures in recent months which could help margins in coming quarters relative to expectations.
The one other assumption worth mentioning: 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. So for many companies, EPS could be boosted by a few percentage points. I think we’re entering 2019 with reasonable earnings expectations by investors with decelerating growth trends appropriately implied in assumptions.