Bonds traded within a narrow range. Remember that at the start of this year, a spike in long term rates of less than half a percentage point over just a few weeks sparked a 10% correction in stock prices. This time, the spike, at least to date, has been similar but the negative reaction has been more muted perhaps because earnings growth has been so strong in the interim.
As we enter the fourth quarter of the year, and recognizing that equity prices reflect expectations 6-9 months ahead, investors are concentrating on the outlook for 2019. There is little reason to expect companies to report disappointing third quarter earnings as they begin to report results later this week and continuing through the end of the month. But it will be what managements say about the fourth quarter and 2019 that will get the most attention.
Right now, earnings for the S&P 500 for 2019 are forecasted to be $175 or slightly higher. With the S&P trading just below 2900, that works out to a forward looking P/E of about 16.5 or about 2 P/E points above historic averages. One can tie that premium to two factors. First, interest rates, despite recent increases, are still lower than historic norms. However, as central banks normalize policy, rates should return toward historic averages putting downward pressure on P/E ratios. Second, P/Es normally climb as bull markets mature and investor moods swing from skepticism to euphoria. That process is ongoing. The transition is always slower after a financial crisis but there is clear evidence of gradual P/E increases since 2011. Whether the psychological lift from the improving mood is enough to offset the impact of higher rates is an open question.
As for earnings themselves, there are also two ways to look forward. On the positive side, confidence is high, real wages are rising and increased investment spending should help to lift productivity. On the negative side, cost pressures are increase as a result of tariffs, rising energy costs, and higher real wages. Companies have generally lacked pricing power during this recovery and one has to question whether margins are going to be squeezed next year.
On balance, therefore, the outlook for 2019 should be more muted than it has been for a couple of years. Interest rate increases take time to affect economic growth. The Fed increased rates once each in 2015 and 2016, twice in 2017 and, prospectively four times this year. Right now, consensus suggests at least two and possibly as many as four next year. Thus, the pace of rate increases, while still moderate by historic standards has been increasing and one can see the effects via a roughly 75 basis point increase in rates along the yield curve in 2018. While there are arguments for and against an acceleration of recent trends looking ahead, the safest guess is that rates will move higher next year. Unless investors become truly euphoric for whatever reason in the interim, my best guess is that we will see some P/E contraction next year.
If I couple that with some revenue acceleration, a combination of continued solid real growth and some lift from inflation, with a modest squeeze on net profit margins, earnings can grow at a 5% rate or better. 5-7% earnings growth with a modest-to-moderate contraction in P/E ratios suggest a year of muted returns.
What can change that? First would be much greater productivity improvement than we have seen. One can make that case. Recent evidence shows some improvement. Perversely, we would see more if the rate of job gains, currently averaging just under 200,000 per month, slowed. The move to the cloud and accelerated capital spending also provide optimism. Second, rising real wages are putting more money in the hands of Americans likely to spend most of what they earn.
But there are other possible changes that aren’t all positive. Population growth is slowing and the reduction in immigration will accelerate that decline. If the U.S. continues to grow faster than the rest of the developed world despite higher than average interest rates, the dollar will continue to strengthen putting pressure on foreign earnings and causing increasing difficulty for developing nations with lots of debt. Finally, the 800-pound gorilla in the room is China. Clearly, the trade war is having some impact. China is trying to combat that will free flowing money but that is only a short term solution. It also greatly increases longer term risks if growth cannot be sustained and borrowers have problems servicing debt.
News doesn’t flow in a straight line. Some days the sun shines and strong economic data sparks enthusiasm. On other days, tariff fights and rising interest rates rule. When the trend line is rising at a double digit rate, the negatives are relatively muted and are not long lasting. But when there is more balance, when growth is only running at mid-single digit rates, the ups and downs tend to even themselves out. Reasonably rapid 10% moves over the next year in both directions would seem more likely than in 2017 or 2018.
None of this is a reason to be negative. We have all been spoiled a bit by strong markets over the past couple of years but nothing moves in a straight line. At the same time, there are no signs of the economic or financial imbalances that suggest a recession or similar economic disruption is forthcoming. Moreover, while the outlook for equities is more balanced than it has been in recent years, rising interest rates suggest very little return likely for bond holders. Cash will provide returns that can offset inflation but not much more. At least holding cash in 2019 is not likely to cause one to lose purchasing power.
What would make me more negative? First relates to China. China is still growing faster than the rest of the world, even with the tariffs. But China accounts for about 15% of world GDP. Thus, modest changes matter. If growth took a more drastic negative return, that would hurt multi-national companies. Second, for whatever reason, if interest rates climbed more quickly than anticipated, that would spark a quick and negative reaction in other financial markets.
What would make me more positive? The ongoing absence of inflationary pressures would be number one on my list. It is unclear how well investors understand the disinflationary pressures of the Internet. If enhanced price discovery continues to limit future price increases, it would mean lower interest rates. While the same pressures would crimp profit margins, the positive impact of lower rates would be stronger. Second, as noted earlier, investor euphoria often swells late in an economic recovery cycle. If we see an IPO and merger wave beyond what we have seen so far, that will serve to lift prices.
For now, as we enter earnings season, the main focus will be on 2019 estimates. If $175 for the S&P next year is wrong, is it too high or too low? We may learn a lot relative to that question in the coming weeks.
Sean Lennon, son of John Lennon and Yoko Ono, is 43 today. He was born on the same date as his father. John Lennon would have been 78 today.
James M. Meyer, CFA 610-260-2220
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