More to Come

Jul 30, 2018 | Jim Allworth


Equity markets have been giving mixed readings. On the one hand, the S&P 500, the Dow Jones, Europe’s benchmark index and Japan’s TOPIX are all still below their January highs. By contrast, the NASDAQ, Canada’s TSX, and the FTSE in the U.K. are all at or have set new highs in recent weeks.

Perhaps even more important, U.S. small-cap and mid-cap indexes have also moved above their January peaks, as have indexes designed to measure market breadth – i.e., the proportion of stocks moving up versus moving down. Small-cap and breadth indexes typically start to move lower on a trend basis months or quarters before the major large cap indexes set their final highs for the cycle. Instead, today, they have been powering higher, suggesting there is more upside to come for the S&P 500 and other large-cap indexes.

And we think there is: the U.S. economy looks to have reaccelerated in the second quarter while most other economies are holding their own; earnings estimates on the street continue to climb higher; and P/E multiples at 16.5x forward earnings for the S&P and 15.1x for the TSX are not demanding. Importantly, those factors we monitor that have reliably flagged approaching recessions ahead of time are all suggesting that no significant global or U.S. economic downturn is imminent. These include the cost and accessibility of credit, employment conditions, as well as new orders and production levels.

Keep a close watch
All that said, changes at the margin for certain factors suggest our recommended moderately-above-benchmark exposure to stocks in portfolios should be accompanied by increased vigilance in the coming quarters.

Perhaps the most important change to note is the shift in tone from the U.S. Federal Reserve’s Open Market Committee. Communications accompanying its June rate increase indicated the collective view of the committee members now looks for two further hikes this year (up from one previously) and an additional hike next year over and above the three forecast previously.

The committee also dropped some longstanding “lower for longer” language in its communiqué. This opens the door for the Fed to normalize policy rates somewhat faster than previously indicated – not a dramatic change perhaps, but one that arguably brings closer the tighter credit conditions that historically have produced economic and earnings downturns as well as more challenging equity markets.

At the same time, global PMIs (economic activity indexes) have rolled over and are now below recent peak levels. While still comfortably within the zone indicating manufacturing volumes continue to expand, they are no longer moving higher. This might be heralding a leveling out of earnings estimates in coming months. In a period of rising interest rates, this in turn could mean the rich price/earnings ratios seen at the January peak might have set a high water mark for valuations that’s difficult to exceed.

For our part, we expect earnings growth alone will be able to power the indexes high enough to deliver worthwhile all-in returns from stocks. However, we expect their trajectory to be more volatile and shallower than the “straight up” double-digit-return runs of 2016 and 2017.

The deal with trade
There is, of course, a growing “wall of worry” emanating from several sources: trade disputes; fractious politics in the U.S., U.K. and Europe; the ever-present risk of geopolitical blow-ups; China concerns. The fate of NAFTA negotiations are front of mind for Canadians (and many Americans), followed closely by deterioration of trade relations between the U.S. and China.

Hopes for a quick NAFTA resolution have faded recently as Mexican elections and U.S. midterms begin to factor into timing assumptions. Even a deal reached now may have to be successfully shepherded through a contentious election season. Agreements by negotiators and then approval by politicians could involve a nervewracking wait well into next year. And the odds of which outcome – benign or damaging – is likely to prevail have swung in both directions more than once.

We expect that, to the extent there are negative outcomes from these negotiations, they will be felt most fully by the economy and by markets in the next economic downturn when it arrives. So far neither the economic and credit indicators we watch nor the stock market itself are suggesting such a downturn is looming.