If the foundation of equity investing is that share prices are a rough approximation of future company profits, then investor skepticism that earnings will grow fast enough can lead to a market correction like the one we saw in early February. Looking at first-quarter earnings reported so far, and where we are in the credit cycle, we still favor growth assets based on relatively healthy fundamental underpinnings. But we are carefully monitoring the downside risks associated with protectionism and other catalysts that could impair growth.
Equities Get Through Long, Slow Recovery
To set the stage for equity markets now, it has been 10 years since the start of the credit-fueled financial crisis followed by a long, slow recovery, prompting the world’s central banks to launch aggressive quantitative easing (QE) policies. In the US alone, the Federal Reserve (Fed) balance sheet climbed from about USD 800 billion to over USD 4 trillion. Even with so much monetary stimulus, Europe was hit by debt-related problems in 2010–2012. Then the price of crude oil and other commodities fell deeply amid a series of China-related shocks in 2015 and extending into early 2016. Equity earnings for much of this period were disappointing, with estimates for financial stocks particularly hard hit as investors around the world continued to worry about deflation and deteriorating global growth.
Accordingly, the post-2008 recovery has been subpar compared to other periods of economic expansion. Figures 1 and 2 highlight the low trajectory of US gross domestic product (GDP) growth and the modest pace of US inflation measured by the consumer price index (CPI). By any number of other metrics, economic indicators have been getting stronger, but not unusually so.
Eventually, QE succeeded in forcing investors into riskier assets in the reach for yield. After the last big correction in January 2016, equities rallied along with the pick-up in global growth and trade. Probably the best example of these forces working well together was in emerging markets (EM), which had a stellar 2017. Coming into 2018, investors were more worried about inflation amid stronger and synchronized global growth and late-cycle stimulus in the US in the form of historic tax cuts and immediate expensing provisions.
High Expectations for Earnings Season
The reasons for the market correction in early 2018 have been discussed in previous blog posts. Since then, US stocks have moved back into positive territory for the year, as investors seem to think earnings will continue to rise. If the S&P 500 estimated growth rate of 17.1% for the recent quarter turns out to be the actual rate, it would be the fastest pace of earnings growth since the first quarter of 2011. Also unusual for this past quarter is the ratio of upward to downward revisions in estimates, reflecting changes in analyst expectations and often considered a leading indicator of where earnings are heading. Ten sectors, led by energy, had higher growth rates going into reporting season than on December 31, when the estimated growth rate for the S&P 500 Index was 11.3%. The potential positive impact of lower US corporate tax rates is largely responsible for this upside to expectations.
We will continue to monitor the earnings scorecard and the earnings revision ratio closely, as disappointments amid such optimism could be negative for equity markets — especially in the most expensive sectors. Even if actual earnings continue to meet or beat estimates, any downtrend in the revision ratio would be evidence that expectations are heading lower. In Europe, for instance, earnings forecasts have started to come down. At an idiosyncratic level, headlines about privacy concerns at Facebook and President Trump’s tweets targeting Amazon may have cast doubt over the sustainability of earnings for some tech stocks. When JPMorgan published earnings beating estimates, that growth was not strong enough to compensate investors for higher-than-expected provisions, and its stock price fell quite significantly. If guidance falls short of expectations more broadly in response to moderating global growth, that could inject more volatility into the markets.
That is not our outlook, however. Overall, we continue to believe this earnings season will live up to the high expectations. Based on the announcements so far, reported earnings have been in line and guidance has been upbeat on the whole.
Credit Cycle Not Pointing to Recession
We also watch the credit cycle for any signs that we may be getting closer to a recession, which would impair earnings growth. Following the typical pattern when a recovery gets long in the tooth, credit spreads tend to widen, as we have seen recently. This could make borrowing costs higher and profitability lower, eventually raising default risk. Based on a number of reasons, that is not our base call for the current cycle. Easy money from central banks has helped lengthen the credit expansion phase. We would be cautious as interest rates return to normal levels, which would imply a higher risk premium for credit. But that might be somewhat offset by plans for lighter regulatory requirements, which could help extend the cycle a bit longer.
Despite Sabre Rattling on Trade, Buying Opportunity for Growth Assets
Even with this broad range of indicators to support continued upside in equities, markets clearly reacted in early April to the prospect that a major trade war between the US and China could throw the rest of the world into a tangle of tariffs. Beyond that sabre rattling, the recent market volatility suggests that investors recognize the possibility of disruption in the political situation. But for now, we maintain overweights on US, Asia Pacific and EM equities as the markets adjust to the inevitable normalization of central bank policy, while inflation remains at a reasonable level after the February scare. As long as the trade rhetoric does not escalate, underlying fundamentals continue to tick along and valuations based on forward earnings stay within striking range of historical averages, we see this environment as a potential buying opportunity for growth assets like equities.
Consumer Price Index (CPI): The raw inflation figure that is released monthly by the US Bureau of Labor Statistics. The CPI calculates the cost to purchase a fixed basket of goods, as a way of determining how much inflation is occurring in the broad economy. The CPI uses a base year and indexes the current year’s prices according to the base year’s values.
Inflation: The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.
Quantitative Easing: An unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
S&P 500 ® Index: A market value weighted index of 500 stocks that reflects the performance of a US large-cap universe made up of companies selected by economists.
Yield: The income return on an investment, such as the interest or dividends received from holding a particular security.
The views expressed in this material are the views of Mark Wills, Frédéric Dodard, Mehvish Ayub, and Ramu Thiagarajan through the period ended April 18, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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 See “Beware the Politics of Deficits and Trade” by Elliot Hentov, State Street Global Advisors IQ Magazine, Spring 2018.