When Tailwinds become Headwinds
What to Expect from Equity Markets and Position Considerations
- Earnings growth slows dramatically and margin pressures build.
- Federal Reserve and other central banks move toward tighter monetary policy.
- Sector and stock selection will continue to focus on industries and companies that should perform well late in this cycle.
A number of factors contributed to the precipitous drop in stock prices during the fourth quarter: the uncertainties resulting from a contentious political environment, unresolved trade tensions, and a Federal Reserve intent on raising interest rates in what appeared to be in an almost ‘autopilot’ fashion. Perhaps more significant, though, is the market’s concern over the outlook for earnings, which are undergoing downward revisions. For 2018, S&P earnings growth is expected to come in at around 21% and to expect continued strong growth this year would have been somewhat unrealistic in light of the maturing benefits from the tax cuts, rising interest rates, and disruptions likely to develop from the ongoing trade wars. As a result, investors are now adjusting to lower and more realistic expectations.
Corporate earnings this year are now estimated to come in around 7%, down from the 10% last September. Furthermore, while current economic data suggests a recession in the US is unlikely in 2019, the risks of a global recession (excluding US) are rising. This deceleration in earnings growth and global economic growth is pressuring investor sentiment and stock valuations. How trade policy evolves will be key to how equity markets perform in 2019, but inflation and Fed policy will also be critical. The tight labor market has put increased pressure on wage growth and higher rates will increase borrowing costs, both of which could compress corporate profit margins.
After a decade of unprecedented global accommodative monetary policy, liquidity is draining out of the system as the Federal Reserve and other central banks move toward tighter monetary policy. As a result, “de-risking” will continue in 2019 as the equity markets contend with less accommodative global monetary policy and a flattening yield curve which is causing a tradeoff between equity and bond valuations, particularly as credit spreads widen retreating to more normal levels. As a result, stock valuations contracted significantly last year. At year-end, the S&P 500 Index was trading 14.4 times expected earnings for 2019, dropping below the 20-year median P/E of 15.1 times for the first time since 2013 with the index exhibiting its largest valuation contraction since 2011.
Furthermore, the equity risk premium (the extra return demanded by investors for owning risky stocks over riskless government bonds) has reached levels last seen in early 2016.
We believe the economic and earnings backdrop can support further market gains from current levels, but those returns are likely to be accompanied by bouts of volatility and corrective phases. Fundamentally, the fair value range for the S&P 500 should be in the 2,500-3,000 range based on historical valuation metrics and our economic outlook. Given the expected volatility, however, the index may over shoot in either direction for short periods.
Current data suggests we are in the later stages of an extended business cycle. However, this is a unique cycle in that there are few excesses, such that the cycle can last longer than many predict. While sales and earnings growth will slow as the cycle progresses, equities can still perform well; but the emphasis shifts from favoring cyclical companies that tend to perform well during the early parts of a cycle, irrespective of quality, to those companies exhibiting sustainable organic growth, lower leverage, pricing power, dividends, and secular growth leaders. Sector and Stock selection will continue to focus on industries and companies that historically performed well in this part of the cycle and that stand to benefit from a reflationary environment and higher interest rates.
We remain over-weight Health Care and Information Technology. Health care has underperformed of late due to a ruling that the ACA may be unconstitutional. However, we continue to believe it will benefit from the strong innovation cycle and its traditionally defensive nature. During above-average volatility, this is one of the few sectors that offer both attractive growth prospects and defensive characteristics. Information Technology has undergone some fairly large changes, as some of its largest companies are moving to the Communications sector. As a result, this sector should be somewhat more defensive in nature, with higher dividend yields and lower price-to-earnings ratios. Additionally, balance sheets appear solid, with large cash balances and relatively low debt. In our opinion, this enables the group to pursue mergers and acquisitions that might help performance by removing competition and consolidating expenses. While we still like technology, we are sensitive to how slowing global growth and a trade dispute with China could continue to weigh on the group. Therefore, we will look to minimize our exposure to those companies negatively affected by tariffs, higher interest rates and/or those that are highly leveraged. From an underweight perspective, we continue to limit our exposure to Financials as they tend to struggle when the yield curves flattens.
While we expect the financial markets will continue to exhibit above average volatility as they contend with many exogenous factors, as long as the data continues to support sustained economic and earnings growth, the secular bull market should re-exert itself, with stocks registering mid- to upper-single digit total returns.