The U.S. equity market weakened further recently amid heightened volatility, dragging many other markets down with it. The S&P 500 extended its pullback to 7.6 percent below the all-time high reached just a little more than a month ago. Year-to-date performance has been teetering between negative and positive territory lately.
We think the U.S. market’s mercurial behavior is a temporary phenomenon. The immediate risks facing equities have not changed our constructive longer-term view because the two pillars for stocks—economic and earnings growth—are likely to continue to provide a solid foundation. Forward-looking indicators are still signaling the U.S. economic expansion will persist over the next year, at least.
However, the business cycle is likely in its later stages and short-term vulnerabilities have been exposed in recent weeks. Equity markets need more time to recalibrate to factor in these developments, in our view.
The U.S. selloff began earlier in the month with the spike in Treasury yields. Fingers also pointed to the Federal Reserve as concerns mounted that it could push interest rates up too far, too fast, potentially constricting domestic and global growth.
A confluence of other issues circled as well:
- U.S. earnings missteps
- Profit margin pressure
- Tariffs, China-U.S. trade dispute
- Global & Chinese growth risks
- Fed policy uncertainty, rates
- Italy/EU budget battle
- Lingering Brexit challenges
- U.S. midterm election angst
Recently, market declines have been triggered mainly by soft corporate earnings reports and cautious management commentary by select high-profile multinationals, and related tariff and China angst.
The single biggest factor that has changed in the past couple weeks is that some cracks have been exposed in the corporate earnings outlook. But at this point, we see them as relatively small ones, not gaping holes.
The U.S. and other markets are adjusting to softer margin trends and other missteps in Q3 reports, which are influencing how to perceive earnings for Q4 and, importantly, 2019.
Slower U.S. earnings growth had been expected for 2019 relative to this year even before the soft Q3 reports because the tax cut boost is dropping out of the data and year-over-year comparisons are tough. But with 26 percent of S&P 500 companies having reported Q3 results so far, we believe the consensus earnings forecast could be somewhat too high and the market action is likely signaling this.
Currently, the S&P 500 consensus estimate stands at $178 per share for 2019, where it has been for a number of months. RBC Capital Markets, LLC’s Head of U.S. Equity Strategy Lori Calvasina is at a more conservative $173 per share level. Her forecast now looks more realistic to us. $170 per share is increasingly being discussed among market participants as a possibility. To get the 2019 consensus estimate down to $173 or $170 would require a reduction of roughly three percent–five percent.
Normally if estimates are trimmed by this modest magnitude over the course of months and toward the end of the year when estimates typically come down, it could be absorbed by the market within a normal consolidation period and at a reasonable pace. But given the long streak of upward earnings revisions that market participants had become accustomed to, the risk of downward adjustments seems more challenging for the market to handle, especially in a volatile environment when a number of other issues are also playing a role in the selloff. We think this will all sort out, but it could take some time.
Just because the consensus forecast might be trimmed modestly in coming weeks and months doesn’t mean it’s on the path toward something worse. The long-term economic indicators that we monitor certainly don’t hint of a potential sharp drop-off in earnings estimates because all of them are still flashing green (see table). This is key because recessions normally cause bear markets and the associated collapse in earnings estimates. The modest trimming of estimates is typically standard procedure at this stage of the business cycle and at this time of year.
The heaviest losses are in Asia
Year-to-date declines of select equity indexes
Source - RBC Wealth Management, Bloomberg; data through 10/25/18; data in local currencies
Major economic indicators still in expansion mode
RBC Wealth Management U.S. economic indicator scorecard
Source - RBC Wealth Management, Bloomberg, FRED Economic Data St. Louis Fed
Trade war tentacles
While concerns about the 2019 earnings outlook are a key cause of the recent downdraft in equities, the specific forces behind the soft Q3 reports have been an additional drag on most markets.
The U.S. tariffs on steel and aluminum and the U.S.-China trade dispute are common factors cited by management teams that have stumbled in Q3 or warned about future quarters. Input costs are rising for companies that use steel and aluminum or other goods with tariffs in their manufacturing processes. The tariffs don’t discriminate. They are impacting select U.S., Canadian, European, and Asian companies.
All of this raises questions about how long the tariffs will be in place. After all, it’s tough to remove them once they gain constituencies and the steel tariffs have definitely gained constituencies—U.S. steel workers are back on the job and wages have risen.
The market is also well aware additional U.S. tariffs could be imposed on China, and China could retaliate by raising non-tariff barriers. The broader, deepening geopolitical rivalry between the two countries is also on our minds.
The reality is that tariffs and trade disputes are uncertainties for the 2019 global economic and earnings outlooks. Sentiment in the U.S. was rather complacent about trade for many months and the market shook off tariff headlines. But now sentiment has shifted, mainly due to management comments and the realization the U.S.-China trade dispute could take time, perhaps quite some time, to sort out.
The valuation silver lining
Even with the existing tariffs and near-term earnings risks, it’s important to consider that the vast majority of Q3 earnings reports have been solid. S&P 500 earnings are currently on pace to grow almost 24 percent y/y (roughly eight percentage points of that comes from the tax cut boost). Among companies that have reported so far, about 82 percent have exceeded earnings estimates, well ahead of the strong trends in previous quarters and far above the long-term average. Revenue beat rates have moderated, although they are near the long-term average.
Importantly, investors should not lose sight of valuations. They’ve only become cheaper during this selloff. For example, the S&P 500 is trading at 15.6x RBC Capital Markets’ 2019 estimate of $173 per share. This is below the long-term average of 16.2x since 1990. Other markets outside of the U.S. are even more reasonably valued or cheap.
So far this pullback is similar to previous choppy periods
S&P 500 Index since 2008
Source - RBC Wealth Management, Bloomberg; data through 10/24/18
Despite Q3 missteps, we still expect earnings to rise in 2019
S&P 500 annual earnings per share and estimates
Source - RBC Wealth Management, RBC Capital Markets U.S. Equity Strategy, Thomson Reuters I/B/E/S; 2018 and 2019 data are RBC estimates
Manage the mood
Our longer-term view remains that investors should give equities the benefit of the doubt as long as the economic, credit, and earnings cycles remain favorable for stocks. Our forward-looking economic indicators remain intact, and we still expect U.S. earnings to grow at an average pace in 2019 alongside an attractive valuation. The U.S. secular bull market should stay intact as this mercurial behavior runs its course.