About a quarter ago, we put forward the thesis that the sudden deterioration in US trade talks had re-injured business confidence at a critical moment. In a global economy still recovering from a Q4 demand shock, the hit to confidence would create a negative feedback loop for growth: hesitant business spending = declining GDP = further reductions in business spending. This would become evident with Q2 earnings reports, where company guidance for the rest of 2019 would meaningfully undershoot growth expectations priced into equity markets, and those markets would correct.
About 50% of S&P 500 constituents have now reported Q2 earnings and the thesis is proving to be correct: earnings have contracted by 2.5%and 13% of companies have given negative guidance for the rest of 2019. Said differently, that means we are technically now in an earnings recession (two quarters of earnings declines in a row) while an above-average-yet-not-huge number of companies are seeing their business outlook further deteriorate.
The “yet-not-huge” part is important though, because it has ended up being far outweighed by the coming round of monetary policy easing that started to emerge in May. The Fed will make an insurance-cut of at least 25 bps this week. Other countries – notably Canada – have been much slower to respond, although this past Thursday the ECB did set the stage to cut rates and extend its QE program in September. The results have been the US equity market gaining 3% since May and equity markets in the rest of the world hovering around flat. In an earnings recession, that’s a pretty impressive result.
Looking forward, we appear to have the same set-up for the remainder of 2019 and into 2020: earnings that are likely to disappoint relative to equity market prices, offset by the possibility of substantial further central bank easing. The former seems fairly clear – the S&P is trading at ~17x P/E based on forward earnings, which is both above-average and presumes 10% earnings growth next year despite this year’s contraction. The question is really about central banks then – will they keep cutting enough to make that earnings growth possible and that valuation reasonable?
The odds of them doing so have certainly increased since May, and as a result my thesis of negative equity market performance has less likelihood of being correct now. In fact, it is entirely possible that recent equity market gains could trigger a minor feedback loop where FOMO causes portfolio managers chase performance through the coming 5 months into year-end. Either way – markets are probabilistic and the odds have changed; and when that happens, you have to adjust your Prior. Note though that the Fed is now the whole story for equities now. If they appear to walk back from easing at some point through the balance of 2019, the equity market reaction will be meaningfully negative – so equity markets are uncomfortably risky at the moment, with a positive outcome based on the kindness of strangers.
Summer is a natural time for reflection, and as it happens the widely-followed Howard Marks of Oaktree has been doing just that on the Fed’s new shift to easing. He released a memo on the topic this week questioning the second-order effects of the Fed choosing to ease now: wouldn’t it be better just to get a garden-variety recession over with today, and isn’t the Fed going to be left without bullets when it really needs them? The memo is attached.
Lastly, we would be remiss not to highlight the dramatic increase of odds for a hard Brexit. After the new UK Prime Minister’s demands were rejected at a perfunctory meeting with the EU, he has put the UK and the EU on notice that Brexit will happen in 90 days “by any means necessary”. While a majority of British MPs have previously said that they’ll vote to prevent a hard Brexit, there is an element of socialization now occurring with the idea that could reasonably lead to it becoming a reality.