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The market has been on a wild ride since early October. Despite solid reads from the US economy, the sell-off of US stocks has continued. Even the better than expected GDP report could not reverse the pessimistic outlook. There are plenty of plausible explanations, but none addresses the key structural shifts that we would need to be convinced. The broader US economy has been firm, yet the DJIA is down 10%. Fears of rising interest rates, escalating US/China trade tensions, skepticism on global growth, geopolitical tensions with Saudi Arabia, mounting debate between Italy and the European Union on budget spending, US political pressures… these are just a few of the issues at hand. Although headlines provide plenty of distractions, we must remember that it is quite normal for markets to undergo sporadic corrections; this is an aspect of behavioral economics which, while extremely influential on the direction of markets, is hard to define.
In our opinion, the two biggest worries for investors are rising interest rates and the US/China trade war. The question as regards interest rates is this: what will higher rates do to US economic expansion? Also, how will a trade war damage China’s already weak growth and erode corporate profits? Bond prices have been falling due to rising interest rates, especially at the long end of the curve, and this hurts company multiples, with valuations based on earnings in the distant future. This is natural and a clear rationale for the rapid decline seen in the technology sector. However, the broader and deeper fall is likely due to the negative US economic outlook. The dominant thinking is that the recent acceleration in US GDP was due to Trump’s fiscal deficit spending – an impulse that is now fading. This would suggest that without the artificial stimulus (we don’t expect a 10% middle class tax cut), a natural business cycle – with the US is in a late stage – would take over. Investors are now doing a deep drill into economic reports and company quarterly releases to uncover evidence of further weakness.
Interestingly, despite a few high-profile earnings misses, the vast majority of earnings reports have been positive. Third-quarter earnings are above analysts’ estimates and on track to come in 22% above Q3 2017 profits. And this is driven not just by the benefits of tax reform, but by “selling more stuff”. However, valuations are more about the future than about past performance. Two-thirds of companies have provided forward guidance indicating that their revenue and profit targets are below analysts’ expectations. This is also not unexpected given the higher analysts’ forecasts that were generated to support “buy” recommendations. The percentage of companies issuing negative guidance is trending below the five-year average.
Looking further afield to the issues of Brexit and Italy, the timing of risk-off trades remains suspect. There has been neither a sudden surge in global volatility nor an unexpected collapse in the corporate earnings outlook. Even polls around the contentious US midterm elections remain stable. Housing statistics have weakened marginally, but this may have been driven by hurricanes and the ongoing supply shortage. Perhaps the first signal that weak global demand will damage corporate earnings came from the semiconductor industry, which is a bellwether for global growth. Investors were told that demand was slowing for a broad range of semiconductor chips powering anything from automotive components to consumer electronics. While pure chip supplier Texas Instruments’ forward outlook was weak, Intel, which is involved in cloud server hardware, issued a more positive outlook. Boeing, another canary in the coal mine, reported third-quarter adjusted earnings of $3.58 per share, 11 cents above Wall Street expectations, and its 2019 outlook remains strong; yet the stock is 16.50% off the highs.
History shows that the S&P 500 has seen a 10% decline approximately every other year since 1950, and a 5% decline every year. Even recession-driven falls tend to be transitory events. But all are extremely difficult to predict. The reality is that investors are nervous after such an extreme bull run. The slightest sign of weakness has exacerbated these concerns, pressuring investors to dump in order not to miss the trade. We suspect 2019 will be dominated by this “fear trade”.
However, if you’re not convinced, it’s time to get defensive: we anticipate increased volatility ahead.