In early August, we made the decision to move tactically underweight equities. Adopting a more cautious stance is perhaps not surprising given this is now the longest economic expansion on record. However, it’s not the longevity of this current expansion, nor equity market valuations, that caused us to adopt a more defensive position, but signs that the ongoing trade dispute had pivoted further away from a resolution. Going forward, what are the signposts and concerns that need to be resolved to see this position change? In this article, we discuss four factors that will be important in determining the future direction of equity markets.
Despite ongoing growth concerns, the precipitous fall in global bond yields has lent significant support to equities as an asset class, resulting in global equity markets trading to within 1.2% of record highs at the end of July (the S&P 500 and S&P/ASX 200 indices did in fact trade to record highs). Since then, a significant rise in volatility has coincided with a pull-back in global equity markets from their peak, justifying our more recent cautious stance.
Over the near term, equity markets are likely to be reactionary to geo-political events. But, taking a step back and looking longer term, the focus for investors shouldn’t be on whether tensions ease but whether the ‘America First’ economic policy that first saw 30-50% tariffs imposed on solar panels and washing machines over 18 months ago, and since extended by both sides, has already permanently altered capital allocation and spending decisions for corporations.
Has the dovish monetary policy tilt by global central banks been enough to ease financial conditions, and is there enough fiscal policy urgency across the world to spur renewed business investment? It is difficult to forecast—but, as we explain below, keeping abreast of the outlook for the global banking system, corporate earnings, various leading economic indicators and the yield curve should allow investors to position portfolios accordingly.
1. Earnings growth and profit margins will dictate the direction of equity markets
In many ways, the trade dispute has captured headlines, but it is the impact on underlying corporate behaviour that we should be most focused on. Since the last quarter of 2018, global manufacturing indices have been steadily deteriorating (see the chart on the following page). The US, India and Australia are the only major economies that have a manufacturing sector that is still expanding (albeit their rate of expansion continues to slow). While trade tensions are weighing on corporate confidence and various Purchasing Manager Indices (PMIs), it is how this feeds through to corporate profitability and profit margins that is likely to be the bigger driver of equity markets.
While tariffs and trade issues have no doubt begun to impact company earnings expectations and are certainly impacting the various PMIs, most of the accelerated slowdown in US earnings so far in 2019 can be explained by the roll-off effect of 2018's corporate tax cuts. Looking ahead, it will be the pace of any deterioration in corporate profits and margins that will ultimately dictate the direction of equity markets.
As we suggest later in this article, a decline in S&P 500 forward earnings growth below 0% would likely bring an end to the ‘bad news is good news’ dynamic that allowed equities to rally earlier this year. Forward earnings growth was nearly 20% at the trough in equities in late 2018, which allowed for a very powerful rally in the S&P 500 index in H1 2019. However, as we conclude the Q2 earnings season, that growth has deteriorated to just 2.5% (from 4.3% just prior to the start of the earnings season). Furthermore, if we look to remove distortions created by tax and interest payments, forward earnings before interest and tax (EBIT) growth is now negative. Additionally, there are now 148 companies in the S&P 500 index with year-over-year forward- earnings growth in negative territory. This is more than twice the number seen in December of 2018.
Importantly for investors, in the past, periods of declining earnings have been associated with declines in the S&P 500 index. Sentiment tends to suffer when earnings growth turns negative, paving the way for a ‘glass half empty’ mentality. This weight on investor sentiment often results in price to earnings (P/E) compression and, combined with deteriorating earnings, is a bearish backdrop for equity markets.
US profit margins are on track to suffer their first fall since 2015 as companies increasingly struggle to pass on costs of rising labour, transportation and raw materials to customers. Analysts’ consensus forecast is for net profit margins to contract by 40 basis points in 2019 to 10.9%, albeit a still high level. Margins are on track to record their largest drop since Q4 2015.
2. If bank profitability falls, so does the availability of credit
The recapitalisation of banks post-GFC means the system is now on a much stronger footing than it was heading into 2008. This time, however, the concerns don’t revolve around capitalisation, but the global banking system’s ability to lend profitably and extend credit. Across the globe, the flattening of yield curves (and in some cases inversion) is placing significant pressure on bank net interest margins. This situation is further compromised by the fact that, with already low interest rates on deposits, the ability of banks to reprice depositors to compensate for this is challenged (i.e. funding costs reach a natural floor).
Because banks make most of their money by borrowing and lending at different interest rates, the slope of the yield curve has important implications for their profitability and equity values—i.e. it has the potential to affect banks’ decisions about lending and risk-taking. Naturally, if a flatter yield curve reduces bank profitability, there is a risk that the availability of credit is rationed, in turn impinging on an economy’s ability to grow.
In the US, with its deep and alternative capital markets, this is less of an issue. In Europe, however, where approximately 70-75% of companies and 90% of households receive funding from banks (versus around 30% in the US), the direct linkages to the economy are much stronger. Furthermore, the profitability of the European banking system is challenged by its very competitive landscape. The top five US banks capture 40% of the US lending market whereas the top five Eurozone banks capture around 20%. With 6,000 banks in Europe, this makes it a very competitive market. Globally, many banking sectors are trading at critical technical levels (see charts below). Falls below these long-term support levels would be a worrying signal for the direction of economic growth and equity markets more broadly since the financials sector remains the second largest equity sector globally.
3. Economic indicators that correlate closely with the S&P 500 index
A raft of economic indicators (some more relevant than others) have been decelerating and disappointing relative to expectations over the course of 2019—the Cass Freight index, retail earnings, durable goods, capex, PMIs, semi-conductor inventories, oil demand and restaurant sales. These are, of course, countered by other indicators, such as the strength of job markets, housing permits and retail sales. To single out any one indicator is difficult. Nonetheless, we are paying particular attention to the following indicators, which we believe could signal a further deterioration in equity markets:
The Morgan Stanley Business Conditions index (MSBCI)—The MSBCI Composite index and one-year forward earnings revisions have a correlation of approximately 80%. The May reading posted its biggest one-month drop in history and came very close to its lowest absolute reading since December 2008. This index has a very tight relationship with the ISM New Orders index, S&P 500 index earnings revisions and the year-on-year change in the S&P 500. Although the June reading bounced back, it subsequently fell again in July. Any further deterioration in this indicator would be worrisome for global equity markets given the above linkages.
The ISM New Orders index—The chart below shows just how closely the ISM New Orders index correlates with the year-on- year change in the S&P 500 index. The S&P 500’s year-on-year return peaked around 24% in early 2018, around the time the ISM New Orders index hit its own cycle high of 67.4. Both indices have been trending lower ever since. Statistically, an ISM New Orders index that is less than 50 (i.e. contractionary) is the level of demarcation between earnings growth and an actual contraction in S&P 500 earnings. This series has contracted sharply this year and was at 50.0 in June before rebounding slightly in July to 50.8. A fall below 50 would suggest that earnings growth may deteriorate further and turn negative.
4. The future shape of the yield curve matters
An inverted US 2-year/10-year yield curve has a very good history of predicting US recessions. For the record, so too does the three-month/10-year which was the focus a year or so ago. The inversion of the US curve is a worrying sign, although there is significant debate regarding its relevancy.
UBS recently noted, “more than weakness in US growth, the inversion of the yield curve makes a statement on lacklustre growth in the rest of the world” and Credit Suisse observed that the last five occasions that the yield curve correctly predicted a US recession, the US Federal Reserve was tightening policy—not easing as they are presently. Indeed, many past and present central bank officials have observed that unconventional monetary policy is distorting the long end of the yield curve. The timing signal from an inverted curve to a recession is quite variable, with Bank Credit Analyst Research suggesting it is between six and 18 months and differs every business cycle.
One thing that does bear watching is the shape of the yield curve moving forward. As Société Générale strategist, Albert Edwards, has repeatedly noted, a far more immediate and present danger of recession occurs after the yield curve inverts, and when a rapid steepening takes place. Such an event usually informs investors that the cycle is over and is a precursor to tougher equity markets. This view was corroborated by Goldman Sachs as recently as June, when it observed that, since the mid-1980s, significant drawdowns in stocks started only when the yield curve began steepening after being inverted. If the yield curve does begin to steepen, having been (briefly) inverted, it would be worrisome for equity markets.
Earnings growth is the strongest driver of share price gains
Ultimately, earnings growth over time tends to be the strongest driver of share price gains and it’s important for investors to closely monitor those variables that correlate strongly with earnings growth. With almost 150 companies in the S&P 500 index now forecast to deliver negative year-on-year earnings growth, the continuation of the current bull market likely rests with the direction of earnings over the course of H2 2019. In isolation, the factors highlighted above would be worrisome but not cause us to turn more negative. Taken in aggregate, however, if these factors deteriorate further (or indeed stabilise, or improve), it would in all likelihood cause us to re-think our current stance and position portfolios accordingly.
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Sensible, evidence backed analysis. Most stock pickers avoid macro postulation wherever they can "not my job", "I'm not an economist", "waste of time", "I'm paid to invest" etc., BUT most are also portfolio managers. On that score I am encouraged by this sort of measured data led observation (not prediction) on broader market conditions. It implies the acceptance of an organisational duty of care to support clients with their, all important, asset allocation decisions. Differentiation driven by real value add rather than unabashed marketing. Good stuff! Thanks Todd. Thanks Crestone