Confirmation of a shift in monetary policy direction from the Federal Reserve took place in the third quarter of 2019, as the Fed cut rates by 0.25% both in July and September. The move back to an easing stance and renewal of cheap money has helped lift the stock market through price-to-earnings multiple expansion (i.e., investors are willing to pay more per dollar of earnings). In fact, US stocks are currently exhibiting the best first nine months of a year since 1997. Meanwhile, the S&P 500 Index dividend yield briefly moved higher than the 30-year Treasury yield and the 10-year US Treasury bond yield has fallen more than a full percentage point, from 2.66% at the beginning of the year to 1.65% at the end of the quarter. It is likely that interest rates remain depressed for some time due to a slow growth economic environment, but we see little near-term risk of recession as a result of easier financial conditions and still-robust US consumer spending. The record-long US economic expansion is supported by healthy household spending and appears unlikely to morph into a deeper downturn any time soon.
The global economy continues to evolve, but representing 25% of global GDP, the US remains the largest swing factor. It’s not exaggeration to say that the US consumer is carrying the rest of the world on its back. As Blackrock recently put it, “for the umpteenth time this recovery, the US household sector appears to be keeping the global economy out of the abyss. The good news: this is likely to continue.” The bottom line is that it is probably a mistake to bet against the US consumer. If there’s one chart to pay attention to over the coming quarters, it’s the chart of personal consumption expenditure growth rates. We see little that should disturb this trend: Unemployment sits at a 50-year low of 3.5% with small business increasingly reporting labor shortages, wages are growing at a reasonable pace, personal savings rates have seen an uptick, and activity growth in rate-sensitive sectors like durables consumption and housing presenting signs of recent rebound.
More bearish commentators will point toward the Institute for Supply Management (ISM) manufacturing index dropping from 51.2 in July to 49.1 in August, the first time since August 2016 that the index fell below 50 and indicated a contraction. For September, the U.S. manufacturing Purchasing Managers’ Index (PMI) came in at 47.8, marking the second consecutive month of contraction and the weakest reading for the index since 2009. However, investors should note that manufacturing only accounts for approximately 10% of the US economy, and that number has been shrinking progressively over the years, whereas services account for roughly 70% of the total economy. Furthermore, intellectual property products (IPP), primarily software and R&D, has grown from around 7% to 34% of capital expenditures (capex). IPP has become the lifeblood of industry. Without investment in software and R&D, companies may soon find themselves irrelevant. As a result, businesses have been reluctant to cut this area of expenditures, providing a floor under capex and reducing the risk of recession.
Real GDP has eased to 2.3% on a y/y basis, the slowest pace in two years, confirming that economic activity has lost momentum. Nevertheless, for the US in particular, slow-but-positive growth is the investable outcome as the base of consumption spending and labor trends makes it difficult to envision a serious slowdown over the coming quarters. While some indicators may flash warning signals for the economy, we do not see sufficient weakness across a broad enough spectrum of indicators to make a recession call. Given current facts and circumstances, we have seen credible prognostications of recession developing at some point over the next 12 months in the 20% to 30% range. Even then, those worst-case scenarios point toward any recession being relatively mild in scope. Potential disruptors for consumer confidence could come in the form of a further increase in tariffs on consumer goods coming from China or elsewhere, a prolonged military conflict in the Middle East that disrupts the global market for oil, or a messy “no deal” Brexit policy shock prompting recessions across Europe. Regardless, the consumer spending trendline will be closely monitored, given its sensitivity to households’ desire for precautionary savings and expectations for future earnings.
Markets appear to have priced in an additional 0.25% of easing in 2019 and 0.50% in 2020. Our view is that this may prove to be a bit excessive, as we remain more optimistic and expect slowing fundamentals to stabilize. While geopolitical risks continue to ebb and flow, some measures of monetary accommodation are at their best since 2010. The fourth quarter will likely bring more clarity on how the Fed wants to balance economic trends in the US with easing pressure being created by other central banks, but we believe that monetary accommodation will remain substantial. Within the saga of US – China negotiations, several meetings are slated for the upcoming weeks with the possibility of a deal to be signed at the APEC Summit in Chile in mid-November. It remains highly unlikely that any short-term deal solves long-term strategic issues such as technological dominance and implications for national security, but a formal agreement of some sort, followed by a more complete deal, would lift a cloud of uncertainty hovering since early 2018.
On the back of slightly positive corporate earnings growth in 2019, market expectations are for a reacceleration to over 10% earnings growth in 2020 as well as 2021. As we close in on year-end, we enter the time frame where investment analysts historically have started scrutinizing their 2020 assumptions more closely. While we do anticipate forward-looking corporate earnings expectations to come down somewhat, a meaningful deterioration in earnings outlook would require re-evaluation of the US stock outlook.
As the global economy appears poised for a low-growth environment with heightened uncertainty going into 2020, we must be clear that proper portfolio allocation is becoming ever more imperative. Stock selectivity and price valuation matters, especially when several top-down indicators suggest that earnings quality is deteriorating. This corporate behavior is typical when top-line revenue growth becomes harder to generate and pressure increases on management teams to push the envelope. To combat these trends, investors must be aware of spreads between GAAP and operating Earnings-Per-Share (EPS), year-over-year earnings growth minus EPS growth, sales growth, and pre-tax margins. We are in the late-stage of a long economic and market cycle, which means the easy money has already been made. While challenges exist for investors, we are not ready to call the end of the current equity bull market. We do, though, advocate for raising portfolio resilience.
Turning more defensive is not the same as adopting a risk-off stance, as we remain committed to being invested and finding opportunities to help clients meet their financial goals. Within managed accounts, our stock holding focus tilts toward investor friendly companies exhibiting quality earnings and growth, while income-generating call and put options bolster overall yield and portfolio stability. Low correlation fixed income and gold assets provide additional diversification and preservation protections. Investors must remain nimble, look for tactical opportunities to capitalize on volatility and construct portfolios with increasing care.