Robust growth comes at a price
Last quarter we wrote about “rhythm” and “risk” for the outlook. “Rhythm” was the idea that the economy and corporate earnings were likely to continue humming along on the back of the big fiscal stimulus program approved by Congress. We believe that has largely played out and, if anything, U.S. economic and earnings trends have been modestly better than our forecasts. The challenge for financial markets is that this recent strength is being projected far out into the future. For example, equity analysts’ 5-year-ahead earnings growth estimates for the S&P 500® Index have been raised to above 16% and as of Sept.14, 2018 stand at their highest level since 1999. Economists have similarly ratcheted up their forecasts for U.S. real GDP growth in both 2018 and 2019. We agree with the notion that the U.S. economy and corporate earnings are likely to remain healthy over the next six to 12 months. But against such elevated expectations it is difficult to see where the next positive surprise can come from for markets.
Meanwhile, the Fed is responding to U.S. macroeconomic strength with a steady program of quarterly rate hikes. To be clear, the Fed has not taken the punch bowl away yet, but with the U.S. labor market pushing beyond full employment, and core inflation at 2%, there is a strong impetus for the Fed to gradually move policy rates into restrictive territory. Some market commentators have pointed to stress in emerging markets (e.g. Argentina and Turkey) as a catalyst that could slow the Fed down in the short-term. We disagree. The domestic U.S. economic picture is simply too strong right now to warrant a response to external concerns. (Supporting this assessment, the green shading in the table below denotes conditions that are supportive of continued rate hikes).
Emerging market stress would need to get much worse to slow the Fed down right now
Source: Russell Investments calculations. The data shown are three-month averages as of date shown to the left. This averaging process is meant to capture the idea that the Fed focuses on the trend rather than any individual data point in formulating a policy decision, u3 denotes the headline unemployment rate. NAIRU denotes the non-accelerating inflation rate Of unemployment, Core PCE (personal consumption expenditures) inflation is Shown on a year-over-year basis. The neutral rate is an average of the Laubach Williams (2003) and Holston, Laubach. Williams (2017) estimates. LTCM's near collapse refers to the large hedge fund Long-term Capital Management.
We expect U.S. fundamentals to remain strong enough to justify another rate increase at the December meeting, but this decision is less certain. A key source of risk between now and December is U.S.-China trade policy. On the surface, the U.S., as a relatively closed economy, should be more insulated than other international markets from trade risks. Indeed, there is little evidence thus far to suggest that trade concerns have derailed business confidence, hiring or capital expenditures. But this is clearly a major risk on businesses’ radars. We are watching monthly business confidence measures in the regional Fed manufacturing surveys for any early warning signs of slippage, as well as the spread between input and output prices for evidence that tariffs are squeezing profit margins. So far, so good. Barring a major trade policy mistake, we expect the Fed will be able to deliver another two to three rate hikes in 2019.
The 10-year U.S. Treasury yield stands at 3% at the end of the third quarter (right on top of our mid-year forecast). We still think a 3% baseline forecast for the 10-year yield is appropriate. Upside risk to U.S. yields from inflationary pressures and Fed rate hikes are offset by downside risk to yields from an extreme speculative short position which makes U.S. Treasury yields vulnerable to a sharp rally if the economic picture deteriorates. Taken together, our preferred positioning on U.S. government bonds and U.S. duration is close to neutral.
The spread between the 10-year and 2-year Treasury yield has flattened to around 20 basis points as of Sept. 15, 2018, and prevailing flattening trends suggest an inversion in the yield curve is possible around the turn of the year. Inversions have historically served as a reliable early warning sign that a recession could occur over the next nine to 18 months. In the current context, this means recession risks may be elevated around late 2019 or 2020. However, there is an active debate among economists today as to whether low-term premia (which is the amount by which the yield-to-maturity of a long-term bond exceeds that of a short-term bond) are distorting the signal from the yield curve. While we recognize the conceptual merits of this argument, we also recognize that prominent economists have wrongly shrugged off inversions in the past. And we recognize statistical evidence which suggests the yield curve is a powerful predictor of recessions even after controlling for low-term premia. From a risk-management perspective, we plan to take the warning signal from an inversion in the yield curve seriously should it occur.
- Business cycle: Slightly positive. Corporate profits have come in ahead of schedule in 2018, with 25% earnings growth in both Q1 and Q2. We expect profit growth to gradually taper going forward. Elevated industry consensus expectations for the economy and earnings in our view limit the potential for current cyclical strength to drive markets.
- Valuation: Very expensive. The Shiller P/E ratio for the S&P 500 stands at 33x as of Sept. 15, 2018, reaching its highest level ever outside of 1929 and the late 1990s. Our value conditional framework suggests the expected total return on U.S. equities over the next decade is likely to be very subdued.
- Sentiment: Slightly positive. Price momentum is stronger in the U.S. than other regional equity markets as we begin the fourth quarter. We do not see compelling evidence that U.S. equities are overbought right now.
- Conclusion: We maintain a modest underweight preference for U.S. equities in global portfolios on the back of their expensive valuations.