Signs of economic weakness are pervasive. Quantitative evidence from economic reports is depicting an obvious economic slowdown. Additionally, qualitative evidence, such as “expert” commentary and recession related media headlines, means the average American hears about an upcoming recession daily. After reading the headlines of poor economic reports and bearish commentary, one would expect equity markets to reflect this negative outlook by falling and trading near cycle lows. However, global equities are up 16% this year and are only 4% below their one-year high. Let’s examine this phenomenon.
On the economic side, the U.S. economy peaked about a year ago. Both the manufacturing side and, to a lesser extent, the service side, have weakened since last summer. For example, the chart below shows the outright freefall in manufacturing. The ISM Manufacturing Index has fallen below 48 versus over 60 in the summer of 2018. A reading below 50 typically means the manufacturing economy is in contraction. The ten-year period below shows the reading now sits at a 10-year low.
In examining business confidence, both the one year change in small business spending intentions and CEO confidence are in precipitous decline. Notably, both of these measures are below the level where they bottomed during the late-2015 early-2016 manufacturing slowdown and earnings recession. When these indexes fall, business investment tends to follow them lower.
Economic weakness has spread into the housing industry as well. Not only have home sales been tepid for most of the year (lower chart), but the major home price index is now up only 1.6% year over year – the slowest pace of growth in seven years.
The economic weakness has caused S&P 500 earnings estimates to fall nearly as fast as the weakening economy. In the following chart, the lower line shows the 2019 earnings per share estimate for the S&P 500 during the last year. One year ago the 2019 estimate was $177 per share. Today it is $163 or an 8% negative revision. 2020 has seen a similar trend as the earnings estimate has fallen from $196 to $181 over the last year, also a negative revision of 8%. At this level, the S&P 500 trades slightly above 16 times 2020 earnings.
With all of these negative economic reports and negative earnings revisions, why are equities within 4% of recent highs? This answer also has a quantitative and qualitative side. First, on the qualitative side, many believe the economic slowdown has been solely caused by the trade war between the U.S. and China. If the two sides can come to a truce, many believe uncertainty will dissipate and the global economy will rebound. On the quantitative side, due to the economic slowdown, a majority of central banks around the globe are easing monetary policy by reducing interest rates and/or keeping money supply high. Historically when this occurs, not only do many of the major economic indicators bottom, but P/E multiples tend to expand in the future. Unless earnings are plummeting (the E in P/E is falling quickly), equities should rise. Combine this with excessively low valuations outside of the U.S., and we could see continued strength in global equities, most likely with a bias toward foreign equities. The following 15-year chart shows when more central banks are in an easing mode versus tightening, the P/E bias is higher. Depending on the severity of the easing cycle, the bias can equate to the P/E rising by three of four points, equating to a P/E of 19x or so for the U.S.
After the U.S. Treasury yield curve inverted, economic data points fell, and earnings were cut, market sentiment turned quite bearish and it was generally assumed that a recession was imminent. Although the risk of failed trade negotiation is high, and every failed attempt at a resolution further reduces corporate and consumer confidence, the global synchronized easing by central banks should, with a lag, be a tailwind for global equities. The result may be, at worst, an earnings recession (consecutive quarters of negative earnings) as record low interest rates, a relatively healthy consumer, and generally no economic excesses, enable global equities to push through the slowdown.
Notwithstanding our generally positive view for the market, the negative flow of macroeconomic data has heightened our concerns about the economic outlook. During the quarter, we took advantage of the continued strength in U.S. equites to sell holdings that no longer carried a risk-reward that justified holding them in our portfolios. As a result of these sales, account cash levels are currently temporarily elevated. As clients have seen in the past, cash levels tend to increase during market rallies that we view as vulnerable and often decrease during periods of heightened volatility as we take advantage of attractive investment opportunities.
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