Despite China and the US implementing tariffs, the Fed emphasizing that it intends to continue increasing rates next year, and an odd series of US-Russian political events, equity markets have had an excellent month. The S&P is up 3%, Europe is up 1.5%, and even Canada has gained almost 1%.
As anticipated, investor focus has been almost entirely on the start of the Q2 earnings season. So far 20% of S&P 500 companies have reported, with almost 90% of them reporting better-than-expected numbers, and average YoY profit growth coming in at +20%. Even with this month’s price gains, the 12-month forward P/E multiple for the S&P 500 overall remains a not-so-aggressive 16.5x.
On top of this, economic data continues to be supportive. In the US, business spending is clearly re-accelerating after the uncomfortable decline experienced in Q1; and in China, business spending is showing steady growth even as the government engineers a modest slowdown targeted at reducing debt levels. Tariffs notwithstanding, global business sentiment indicators continue to be firmly in expansion territory (for now); and with the 2018 mobile device cycle arriving, economies in Asia ex-China are set to experience their normal seasonal tailwind.
All of this points to the foundation for equity markets continuing to be strong. That said, the set-up for late 2018 and early 2019 is starting to look tougher:
- Earnings growth will fall from this year’s torrid pace, as the tax cut benefit gets lapped – this will most likely surface in Oct/Nov as analysts roll their estimates and price targets forward;
- USD strength likely continues with interest rates rising, leading to an FX drag on earnings for large US multinationals; and, most importantly,
- The Fed will enter 2019 with rates at 2.50%, meaning that absent any meaningful changes from today, the first rate increase of 2019 will invert the yield curve.
All of which leads to the question of how best to position for a market where numbers continue to improve (fundamentals), but perception may start to deteriorate (valuation). We are still working through that ourselves since each cycle has its own nuances - but at least part of the solution would seem to be increasing the percentage of the portfolio invested in lower-valuation equities. Food for thought throughout the summer, particularly when put together with my comments in the last email update about a portfolio needing to be increasingly nimble towards the end of a cycle.