The view from the summit
Summiting a mountain can be an awesome experience, particularly on the way up when climbers are more inclined to pull out a camera for a photo or savour the view with a snack break. On descent, though, the mood tends to change if the climber feels exhausted, behind schedule and eager for the downward move to end. The challenge in mountain climbing, as in finance, is to remain vigilant throughout, particularly on the way down when accidents are much more likely to occur.
Writing this outlook at the end of 2018, it feels very much as though we are at the summit of the current U.S. expansion. Real GDP growth in the middle quarters of 2018 logged in north of 3% – roughly double our estimate of the U.S. economy’s long-term potential. Earnings growth for the S&P 500® Index has been 25% or higher in every quarter this year – a hair-raising pace usually only seen in the bounce out of recessions. And the U.S. Bureau of Labor Statistics shows the unemployment rate stands at a 49-year low. U.S. fundamentals are unequivocally strong right now. The problem is that we think this is as good as it gets for the cycle.
The 2018 midterm elections resulted in a gridlocked Congress. And, given the polarisation of U.S. politics today, that outcome all but guarantees no new material tax cuts or spending packages are likely to be enacted through 2020. Furthermore, members of the Federal Reserve’s Board of Governors – while they’re not there yet – are talking about the need to transition monetary policy into a restrictive setting to ensure the U.S. economy doesn’t overheat. By our estimates, this means that U.S. real GDP growth should mechanically slow from 3% in 2018 to around 2% next year. This cresting of domestic economic activity levels, the punitive base effects from the corporate tax cuts, and accelerating input costs point to an even sharper slowing in U.S. earnings growth from 25% to 8% in 2019.
What we are left to assess is the impact of the slowdown on asset prices. The good news is that the market has already started to do some of the heavy lifting for us. The volatility that we saw in October and November was very much a re-rating of the outlook. Over the last month, industry consensus earnings growth estimates for the S&P 500 Index in 2019 have been marked down from 10.5% to 9%. Those downgrades have been particularly concentrated across mega-cap U.S. technology stocks.
We view the recent sell-off more as a healthy retrenchment in investor sentiment than being indicative of an imminent collapse in the U.S. economy. For example, the downgrades to Apple’s stock in the fourth quarter appear to be driven by concerns about the order book for their latest model of iPhones. These are BIG businesses, but their problems appear idiosyncratic in nature (for now). We also see the U.S. and global consumer in a robust position as 2018 ends with strong income growth, declining unemployment rates and confidence. However, we’ll remain vigilant.
We see greater downside risk to the macro outlook as we peer into the early part of 2020. By then our expectation is that the yield curve will have already inverted, the Fed will have transitioned its monetary policy to a restrictive setting, and the tailwinds from tax cuts and increased government spending will have been fully exhausted. Coupled with what are still expensive valuations in U.S. equities, we are operating as risk managers rather than risk takers. Over the last 50 years, U.S. equities have never peaked more than 13 months before an economic recession.1 If our timing is roughly right in terms of when those macro vulnerabilities manifest, it’s still too early for the equity market to have peaked. As such the path of least resistance looks higher. Still, we’ve entered a very risky phase of the business cycle.
Regarding interest rate markets, we feel quite confident the Fed will keep hiking in the face of recent market turbulence, particularly since its dual mandate of full employment and price stability has effectively been achieved. For a central banker, that means it’s time to get interest rates back to normal levels. And if our forecast for gradually accelerating inflationary pressures is right, it will also be time to take the punch bowl away. We forecast a rate hike in December 2018 and three to four hikes in 2019. Fixed income markets have turned more pessimistic in recent weeks. As such our Fed call leaves us with a bias for a flatter curve and modestly higher rates tactically. However, with recession risks lurking in 2020, our 12-month ahead forecast of the U.S. Treasury yield is still hovering around 3% – and it’s likely to be a bumpy journey to that target.
- Cycle: Neutral. While current economic and earnings growth rates are strong, we look for a sharp deceleration in 2019 as fiscal stimulus fades away. We are encouraged that industry consensus expectations have started to move in this direction. But this is not the stage of the cycle to be taking big bets on U.S. equities.
- Valuation: Very expensive. We’ve upgraded our valuation assessment by a notch with the sell-off in October and November. But assuming a mean reversion lower in corporate profit margins over the next 10 years, our risk premium estimates for the S&P 500 Index remain very unattractive.
- Sentiment: Slightly positive. Price momentum has faded recently but the speed and magnitude of the market sell-off has triggered a few of our contrarian oversold signals. This suggests some scope for a tactical bounce. We’d note the market does not look as oversold as it did in early 2016.
- Conclusion: We maintain a modest underweight preference for U.S. equities in global portfolios, primarily on the back of their expensive valuations.
1 Source: Russell Investments’ calculations based on data from Thomson Reuters Datastream (for the S&P 500 Index) and the National Bureau of Economic Research, as at 20, November 2018.
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