Grace Under Fire

Nov 04, 2019 | Dann Cushing


The balance of probabilities in equity markets has been to the downside since May:...

...the global contraction in manufacturing has been accelerating as tariffs and trade tensions have risen, and simultaneously corporate earnings have turned slightly negative. Central banks (at least those outside of Canada) have been responding proactively to try to prevent this from spilling-over into the labour market and consumer spending. The Fed’s pivot has been the most assertive, moving from raising rates “on auto-pilot” late last year to cutting them by a quick 0.75% when including this past Wednesday’s cut.

In this context, the Q3 earnings season that is now wrapping up seemed likely to reset investor expectations lower, and bring equity markets down with it. In the event however, this earnings season has instead turned out to be surprisingly reassuring: three-quarters of companies have now reported and earnings are tracking 4% better than expected on average. Perhaps more importantly, the commentary coming from management teams on the follow-up calls is also quite positive despite the added tariffs that many had to deal with through the summer. For example:

"We have seen no signs of weakness." – Procter & Gample (Jon Moeller – CFO)

"...consumer and retail spending continues to be strong in the U.S." – 3M (Mike Roman – CEO) 

"...broadly speaking, while it’s slower growth, it’s still growth" – JP Morgan (Jennifer Piepszak – CFO) 

In addition, new US payroll data released this past Friday showed robust growth in October and also revised upward the previously weak number from September. Any transmission of any manufacturing weakness to the all-important US consumer still seems to be non-existent.

This change in backdrop makes the recent rise of the S&P 500 to new all-time highs understandable, even if unexpected. The forward P/E multiple on the index is currently at an above-average level of 18x, indicating that investors are beginning to anticipate (and price-in) a possible bottom in earnings growth. This is probably best evidenced by the Industrials sector – ground-zero for 2019’s economic weakness so far – which has led the S&P higher over the past month by rising 7%.

The challenge that comes with this change in tone for markets, of course, is that we are only one Presidential tweet away from reigniting concerns. The past 4 weeks have been much less noisy on trade threats than usual, and while it’s a welcome respite it could also prove painful to let the memory of it to fade too quickly. This suggests using caution in evaluating how best to participate in an improving market. For example, certain interest rate sensitive stocks and many fixed income vehicles that moved smartly higher through 2019 have simply pulled forward future returns, setting themselves up for underperformance for the foreseeable future. On the other hand, bank stocks seems poised to do well with their share prices generally still below those of two years ago, and with the drag that lower interest rates have had on margins stabilizing on one-hand while positively stimulating new loan growth on the other. The maligned Energy sector also has potential – perhaps more so after tax-loss selling season – due to its correlation with renewed economic growth, low investor expectations and decelerating US production growth. 

Sectors and factors aside, the clear takeaway from the recent earnings season has been resilience by companies during a period of meaningful duress. We still do not view equity markets as a “fat pitch down the middle”, but the balance of probabilities is evolving.