March Investment Comments
So far, 2019 has been kinder to investors than was the finish to 2018. A combination of stronger-than-expected earnings, a more accommodative Federal Reserve, and a strong labor market has supported the full recovery from December’s 9% loss for the S&P 500.
On the earnings front, results are coming in better than expected. According to FactSet Earnings Insight authored by John Butters, fourth quarter 2018 earnings are projected to grow 13.3% for firms that make up the S&P 500 index. This is a fairly solid reading as 66% of companies have already reported. If this earnings growth rate holds it will mark the fifth consecutive quarter of double-digit earnings growth for the index.
Unfortunately, the expectations for earnings growth in 2019 continue to be cut. During much of 2018, analysts were projecting continued double-digit earnings growth. Now analysts expect 5%, about half the prior growth rate, and much of this is anticipated to come later in the year. First quarter earnings are projected to contract 1.7%, with tepid second and third quarter growth of 1.2% and 2.5%, respectively, before a 9% jump in the fourth quarter.
A big reason why earnings growth expectations have slowed is the weakness of overseas economies, particularly China. To illustrate the impact, FactSet reclassified companies that make up the S&P 500 into two buckets: those firms with international sales less than 50% and those with more than 50%. For the fourth quarter of 2018, those firms with international sales less than 50% grew their earnings 16.6% while those above grew only 8.4%. For 2019 the breakdown is 6.7% and 1.9%, respectively.
Another reason for the earnings growth slowdown is weak commodity prices, particularly in the energy sector. Robust earnings for Phillips 66 and Marathon Petroleum in the fourth quarter helped create a difficult comparison for 2019. As recently as last December, the energy sector was expected to make a positive contribution to 2019 earnings growth, but now this has flipped to a double-digit drag.
The recovery of stock prices coupled with these more moderate earnings expectations has moved the forward 12-month P/E ratio to 15.8, about 4% below the level of the five-year average (16.4) and 8% above the 10-year average (14.6). This valuation level is roughly the same as was experienced back in 2015 and 2016. This seems like a reasonably priced market that now could have some upside if earnings growth outpaces modest expectations.
Looking back over the past few months the largest single change that seems to have influenced investor sentiment is the about-face from the Federal Reserve. In December, the Fed raised interest rates another quarter percentage point to between 2.25% and 2.5% and signaled that two more quarter point rate increases were likely in 2019. This confused investors as continuing to raise interest rates conflicted with data showing weakening overseas economies, ongoing trade tensions with China, and slowing inflation. It seemed as if raising interest rates was on auto-pilot versus the “data dependent” philosophy the Fed was presumably following.
After January’s Fed meeting Chairman Powell changed the market’s interest rate outlook by stating that the Central Bank was done raising rates for now. He acknowledged the risks to the U.S. economy’s outlook, which not only included weak overseas economies and trade, but also the negative impact on growth from interest-sensitive parts of the economy, such as housing and autos, as a result of previous rate increases.
Of further importance is the Fed’s evolving thinking with respect to its $4 trillion balance sheet of Treasuries and mortgage securities. The Fed acquired these through its various Quantitative Easing campaigns in order to drive down long-term rates. Starting in October 2017, the Fed has been gradually shrinking these holdings by allowing securities to mature without being replaced. The Fed believed it was important to shrink these reserves as it would allow the central bank to more firmly control interest rates. When the campaign began the Fed had expected the process to take three or four years.
The emerging thinking within the Fed is that the balance sheet may not need to be shrunk that much further. While there doesn’t appear to be any evidence that shrinking the balance sheet has had much impact on interest rates, common sense would conclude that if expanding the balance sheet drives down rates then contracting it would have the reverse effect. There is also the thought that what matters more to rates is the composition of the balance sheet, with longer-dated securities thought to be more stimulative. Currently the Fed’s portfolio is very long-dated as it contains mortgage securities and almost no short-term Treasuries. Therefore, altering the mix of securities toward short-term Treasuries would have more of a contractionary impact on the economy than simply shrinking the balance sheet.
In early February, the Labor Department reported that the U.S. economy added 304,000 non-farm jobs during the month of January, the 100th straight month of gains. In addition, average hourly earnings for all private-sector workers increased 3.2% from a year earlier, the sixth straight month of wage gains greater than 3%. When coupled with a rate of inflation below 2% and falling energy prices, workers are now receiving a nice gain in inflation-adjusted wages. This is good news for the economy as 70% of GDP comes from consumption, and rising wages is a good proxy for the cash flow consumers have available to spend.
While robust job and wage growth is an inflationary concern for the Fed, the good news in January’s report is the slight uptick in the unemployment report to 4%, from 3.9%, coupled with a rise in the share of American adults working or looking for work to 63.2%, up a half percent from a year earlier. These metrics indicate there is still slack in the labor pool that will help keep a lid on wage increases that fuel inflation.
Even with the good news on the employment front, 2019 carries risks. Trade discussions with China to avoid 25% tariffs on over $200 billion of imported goods continue. Weak overseas economies might slide into recession. Divided government could inject additional political risks. However, valuations are reasonable and expectations are modest, creating the possibility that upside surprises are possible.
Dan Boyle, CFA