Turbulence that shook equity markets in October led to the steepest global monthly downturn in more than six years. Investor complacency, so prevalent during the summer gave way to timidity, and at times anxiety, as a number of risks reached critical mass.
Markets are coming to grips with the possibility that U.S. earnings growth could slow in 2019 to a greater degree than previously thought. This combined with softening Chinese and global economic trends were the biggest factors that drove equity prices lower in October, in our assessment.
Concerns that the Federal Reserve could shift toward a more aggressive rate hike pace, potentially blunting U.S. and global growth, were stoked by Fed Chair Jerome Powell’s hawkish comments. Uncertainties associated with Brexit and Italy’s confrontations with the EU also continue to linger.
Federal Reserve federal funds rate in % (upper bound)
The Fed has raised its target rate in recent years, but is still well below the two prior peaks.
Source - RBC Wealth Management, Bloomberg; data through 11/2/18
These risks have not changed our constructive view on U.S. equities because the two factors that influence stock prices the most over time—economic and earnings growth—are likely to be firm enough to push the market at least modestly higher in 2019.
Don’t be Fed up
We think market angst about Fed rate hikes is overdone. “Hawkish” comments and all, the Fed still seems intent to march along at the pace of domestic economic data and it continues to signal a “gradual” approach to rate hikes. Unless this changes, we think the equity market can absorb another rate hike in December and more in 2019, whether three, as the Fed projects, or two, as the fixed income market forecasts.
Rate hikes typically become problematic for the U.S. equity market (and can indirectly impact other equity markets) when the Fed tightens too far, too fast and lenders begin to markedly restrict credit availability for households and businesses.
So far, we’re not seeing signs of this. Quite the contrary, in a National Federation of Independent Business (NFIB) survey of small business owners, only three percent of respondents said that all of their borrowing needs were not satisfied, which is just one percentage point above the record low, and only two percent indicated financing was their top challenge.
Cracks in the earnings facade?
Concerns about the U.S. earnings outlook are warranted.
A reduction in next year’s growth rate had been widely expected by market participants for months, simply because of the arithmetic. The corporate tax cut boost will be dropping out of the 2019 data and robust earnings comparisons from 2018 will make it difficult to achieve strong year-over-year growth.
Q3 results have added another dimension. Thus far, they have been solid overall with an exceptional 27 percent y/y earnings growth rate (includes roughly eight percentage points from the tax cut boost), very good 8.0 percent y/y revenue growth, as well as above-average earnings beats and average revenue beats. However, some high-profile multinationals, particularly economically sensitive firms, have reported subdued margin and revenue trends due to rising input costs related to tariffs and/or wage growth, and warned of such pressures for future quarters. This has raised the possibility earnings growth could slow to an even greater degree than forecast and is forcing market participants to rethink Q4 and, importantly, 2019 prospects.
S&P 500 earnings per share growth (y/y)
Actual & consensus estimates*
Earnings growth is peaking this year, and 2019 estimates may be a bit too high.
Source - RBC Wealth Management, Thomson Reuters I/B/E/S (consensus estimates); data as of 11/2/18
An in-depth RBC Capital Markets analysis of S&P 500 management conference calls during the Q3 reporting season reveals additional cracks. Twenty-three percent of executives believe underlying demand and economic conditions are mixed or weak. Almost one-third of companies cited higher commodity and raw materials prices and wage pressures. Trade and tariffs have been discussed on roughly 40 percent of the conference calls—a sharp increase. Forty-six percent of management teams said the strong dollar was a headwind.
We think all of this signals that the S&P 500 consensus earnings forecast got ahead of itself amid enthusiasm over previous results, and is now somewhat too high. The consensus forecast stands at $178 per share for 2019. RBC Capital Markets, LLC’s Head of U.S. Equity Strategy Lori Calvasina is at a more conservative $173 per share level, which seems more realistic to us.
We believe the consensus could be trimmed to $173 or slightly lower in coming months. Normally the market can absorb such a modest hit to earnings in an orderly way, within a normal consolidation period. 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 get sorted out, but it could take some time.
The U.S.-China tensions are another matter entirely and are much broader in scope.
The trade dispute has been front-and-center for Asian equity markets for months, causing deeper selloffs compared to Europe and North America. The U.S. market practically ignored this issue—until recently. It finally began to account for some of the risks as additional tit-for-tat tariffs were implemented and trade threats mounted, and the conflict widened to include a variety of Trump administration grievances about China’s non-trade practices.
Year-to-date performance of select equity indexes
Trade, tariff, and economic concerns have weighed on Chinese equities.
Source - RBC Wealth Management, Bloomberg; data through 11/2/18; data in local currencies
To us, this dispute is about much more than trade. In previous Global Insight publications our Hong Kong-based analyst Jay Roberts of RBC Investment Services (Asia) Limited wrote that “the trade surplus is not the real issue. And the answers are far from simple. The crux of the problem is that the U.S. is demanding that China change its laws, regulations, and behaviours. That’s a real challenge.” He also stated that “the current approach to China is bipartisan, meaning that what transpires during the U.S. midterm elections may have little impact on policy thereafter. There is even a line of thinking that the U.S.’s new, hard line on China is to attempt to restrict the country from becoming a superpower and protect U.S. hegemony.”
There is a debate among foreign policy specialists about whether the global order is shifting from a unipolar world led by one country, the U.S., to a multipolar world where a few countries dominate—the U.S. and China from an economic standpoint, and the U.S., Russia, and China in the military sphere and other areas. RBC Global Asset Management Chief Economist Eric Lascelles said, “Arguably, the world is already beginning to experience some of the side effects of this transition, as rising tariffs between the U.S. and China are interfering with globalization in much the same manner that prior rivalries did.”
Trade with the U.S. important to China, but it’s not everything
Mainland China’s largest trading partners as a % of China’s total trade (includes exports and imports by country/region)
** The sum of many countries with relatively small levels of trade with China Source - RBC Wealth Management, Bloomberg Intelligence, International Monetary Fund; 2017 data
We think financial markets will be contending with the broader U.S.-China rivalry, on and off, for quite some time regardless of how the trade discussion between Presidents Trump and Xi plays out at the forthcoming G20 summit.
Seeing value in value stocks
Some of the challenges facing equity markets should begin to settle out in the months ahead, such as the shift toward slower earnings growth, clarity about the Fed’s pace of interest rate hikes, and the path of the domestic and global economies.
Other issues, like the broader U.S.-China rivalry, could play out over many years and drift on and off the market’s radar screen, sometimes impacting performance when trade, tariff, and economic growth issues surface. At other times, the rivalry will likely stay in the background, not driving equities in either direction.
Our 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. All of our forward-looking U.S. recession indicators are signaling the expansion will persist for the next 12 months, at least.
Within the U.S., we favor value over growth stocks, and would also tilt toward defensive sectors for the time being.
Since the financial crisis ended in 2009, growth has outperformed value for much of the time on a global basis, including in the U.S. Given the trends so far during this correction and the drivers of these style groups, RBC Capital Markets believes a shift toward value is unfolding.
Value tends to outperform when the 10-year Treasury yield rises, inflation expectations move higher, and GDP growth strengthens, as well as during the latter stage of a bull market cycle. There have been two periods of U.S. value leadership during this bull market.
The Financials sector is the largest within value, and we view it as attractive. Historically, it has been positively correlated with changes in inflation expectations, and those expectations seem likely to rise. Bank stocks are still reasonably valued compared to the broader market and versus the historical average based on our assessment of multiple valuation measures, including price-to-book. Banks’ balance sheets haven’t been this strong in many decades.
We continue to recommend Market Weight exposure to U.S. equities and are constructive on the overall global equity asset class.