We’ll start with one important observation about today’s US equity rally: healthy, happy markets don’t surge 2% in a single session. Worried markets do. Remember the old traders saying – stocks take the stairs up but the elevator down. Even if you take the stairs 2-at-a-time (an excellent core exercise, I am told, if you don’t use the handrails) you don’t get a 2% day.
Still, we’ll take the reprieve as a chance to quickly review the state of US equity fundamentals and valuations. Five points here, with data from FactSet’s weekly Earnings Insight report:
#1: The S&P 500 trades for 15.9x forward 12-month estimates:
- That is lower than the 5-year average of 16.5x, but as we’ll shortly see earnings growth is lower so that makes sense.
- It is, however, notably higher than the 10-year average of 14.8x, supported by low global interest rates.
#2: Analysts expect the S&P 500 to post 3-4% earnings growth in 2019 and 10% in 2020:
- US corporate earnings growth since 2009 has compounded annually at 10.5%, albeit in fits and starts. When oil prices collapsed and US economic growth slowed from 2014 – 2016, S&P earnings flattened at $119/share. It was only in 2017 and 2018 that they resumed growing, reaching $162/share last year.
- Analysts have been reducing earnings estimates all year, down from 6% in January for 2019 to the current 3-4%. Also worrisome: any 2019 growth at all relies on Q4 delivering a 7% comp to last year’s weak period.
#3: There is a wide dispersion in 2019 earnings expectations by sector, but even the “best” growth is unremarkable:
- Sectors expected to show above-average earnings growth: Financials (+7.2% versus 2018), Consumer Discretionary (+6.7%), Utilities (+6.4%), Industrials (+5.2%) Communication Services (+5.1%) and Health Care (5.0%).
- Those with below-average earnings prospects: Energy (-8.8% versus 2018), Materials (-6.4%), Consumer Staples (+0.2%), Technology (+0.3%) and Real Estate (+2.6%).
#4: Despite those collectively sluggish expected results, sector valuations are “country mile” wide:
- Sectors trading for +18x: Consumer Discretionary (20.2x), Real Estate (19.0x), Consumer Staples (18.7x), and Utilities (18.2x).
- Sectors trading for less than 15x: Financials (11.3x), Health Care (14.7x), and Energy (14.8x).
- Clustered around the 15.9x mean S&P 500 valuation: Tech (17.9x), Communication Services (17.4x), Materials (15.3x), and Industrials (15.1x).
#5: Saving the most important for last, the critical issue for US stocks is a disconnect between expected revenue growth and earnings expectations:
- For most of 2019, revenues should grow at 4-5% but earnings growth will remain flat. Earnings leverage – the most powerful source of upside surprises – is entirely absent.
- If revenues fall short, as would happen if the US/global economies falter, then earnings will quickly tip over into negative territory. Companies will respond by cutting staff and investments, and the current cycle will end.
- The Federal Reserve can cut rates all it wants and this problem will still exist. Lower interest rates may elevate multiples, but the fundamental lack of earnings leverage is the real issue facing US stocks.
Summing up, US stocks are neither climbing stairs nor taking elevators; they are on a tight rope, gingerly feeling out the next step. Seeing the Fed unravel a safety net today certainly helps investor confidence. But to transit safely, we’ll need to see corporate earnings leverage lend a hand. We believe it can – no management team can survive very long if they increase costs faster than earnings. But this issue is the critical one for US stocks over the remainder of the year.
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The rally gave us the breather we needed to round up the usual (economic) suspects for a look at what they can tell us about general market conditions. Our basic idea here is that while equity markets may be a bit panicked, we want to see if currencies and fixed income are similarly agitated. Here’s what we see:
#1: Treasury – Eurodollar (TED) Spreads
- The difference between 3-month Treasury yields and 3-month LIBOR
- A signal of dollar availability outside the US.
- High readings (above 0.5) indicate potential stress in the global financial system and are especially negative for emerging market economies.
- Current reading: 0.22
- See data here: https://fred.stlouisfed.org/series/TEDRATE
Takeaway: concerns about a US/global recession are not creating any significant stress in the global financial system just yet. This is likely due to the belief the Federal Reserve will reduce its benchmark rates later in 2019 and keep liquidity flowing.
#2: Italian Long Term Sovereign Debt
- We look at 10-year Italian debt for comparability to liquid German and US sovereign bonds.
- Yields here are 2.52% today, 273 basis points higher than German 10-years and 38 basis points above US Treasuries.
- These spreads are in line with the 1-year average versus Bunds (276 bp) but modestly wider than US 10-years (11 bp).
Takeaway: despite Italy’s political situation, its still-high unemployment rate and worries over Eurozone economic slowing, Italian bond spreads remain at/near historical levels. Another positive sign, in other words.
#3: US Corporate High Yield Spreads
- BB or lower rated corporate bonds versus Treasuries. Data/chart here:https://fred.stlouisfed.org/series/BAMLH0A0HYM2
- Current spread: 470 basis points
- One year average: 389 bp
- Also worth noting: even at their low point for 2019 (back in April) high yield spreads only got back to their 1-year average for a few days.
Takeaway: like US equity markets, high yield is clearly struggling to price the risk of an imminent recession. Spreads are 81 bp above their 1-year average, almost 2 standard deviations away from the mean. The market’s optimistic view about future Fed rate cuts is not helping here.
#4: Investment Grade Corporate Spreads
- BBB or higher rated corporate bonds versus Treasuries. Data/chart here:https://fred.stlouisfed.org/series/BAMLC0A0CM
- Current spread: 136 basis points
- One year average: 128 bp
- Also worth noting: there’s a lot of hand-wringing in fixed income circles around BBB credits, many of which could see downgrades to junk in a recession.
Takeaway: the investment grade corporate bond market is not as fretful as high yield or equities. Spreads are modestly wider than 1-year averages (8 basis points) but this is well within 1 standard deviation (12 bp) from the mean over the period.
#5: Offshore Chinese yuan/dollar exchange rate
- The offshore yuan market, based in Hong Kong, is more indicative of true exchange rates than the onshore market controlled by Beijing.
- The key level to watch is 7.0 yuan/dollar, a level the currency has approached but never breached since trading started in 2010.
- Sharp depreciations – such as those potentially caused by US-China trade war concerns – give rise to concerns of capital outflows.
- Current level: 6.92, less than 1% away from the 7.0 all-time high.
- See chart here: https://www.marketwatch.com/investing/currency/usdcnh/charts
Takeaway: offshore yuan levels are still quite close to the 7.0 level, but holding firm. Moreover, China certainly has the firepower to defend the yuan by selling some of its $1.3 trillion in US Treasuries (Hong Kong plus Chinese holdings).
#6: The value of the dollar
- Investors mostly watch the DXY Index, but we also look at the Fed’s Trade-Weighted Dollar Index
- The DXY Index sits at 97.08, 1% off its May 30th high. More importantly, DXY right now is 5% below its all-time high of 102.21 (October 2016).
- The trade-weighted dollar, by contrast, is at both 1 and 10-year highs right now at 129.6.
Takeaway: even today’s more dovish Fed pronouncements have done little to weaken the dollar (DXY -0.1% as of 2pm ET). While the old rubric that “a strong dollar is in the long-term best interests of the US” is true, it also puts a damper on S&P 500 corporate profitability since 38% of revenues there come from non-US sources.
The bottom line: there’s both good and bad news in this quick tour around the world’s capital market pressure points. On the plus side, this is not 2008 by any stretch of the imagination. Capital is still flowing (TED spreads, Italian bonds, investment grade bonds). On the negative side, marginal destinations – high yield and (of course) equities – are twitchy about what comes next.
In the end, we’re most concerned about currencies just now. We don’t hear much about the dollar’s strength, but it does impact everything from US corporate earnings to Chinese economic stability. A weaker greenback should come as the Federal Reserve starts to move convincingly to easing, which also looks to be the trigger for a sustainable move higher for US stocks.
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Author: Tyler Durden