quity markets were surprisingly strong during the first six months of 2019 as the S&P 500 Index rose 17.3%. However, this outsized gain was, in part, a catch-up to the decline of 7.8% experienced in the second half of 2018. For the 12-month period ended June 30, the total return of the S&P 500 Index was 10.3%, slightly higher than the long-term trend.
More remarkable was the bond performance realized during a period of already low interest rates. Through June 30, the Bloomberg Barclays U.S. Aggregate Bond Index realized a return of 6.1%. This level was about twice the annual returns achieved by the Index over the prior 10 years. Interest rates plunged in the first half of 2019 with 10-Year Treasuries rates falling from 2.68% to 2.05%. The decline continued during the first week of July as bond yields dipped briefly below 2.00%.
The U.S. Economic Outlook
We look for steady deceleration in GDP real growth rates to around 2% per annum. For the time being inflation should be relatively benign. While the bond market is anticipating the Fed will reduce short term rates in the second half of 2019, our judgment is that bond yields will not decline enough to justify increasing fixed-income investments.
GDP growth rates are trending down. The economic lift from the 2017 tax legislation and fiscal stimulus in early 2018 was not sustainable. U.S. annual growth, which peaked last year at 2.9%, will decelerate to around 2% or less next year. Q1 2019 GDP came in at 3.1%, but estimates for Q2 are much weaker with the consensus of economists below 2%. Future growth is limited by a labor force that is fully employed — qualified workers to hire are scarce and unfilled jobs are growing — and by productivity gains that are projected to remain at historically low levels.
Investment managers like us, who were trained in Keynesian economics, find it hard to comprehend how an economy that has been expanding for 10 years is not generating high inflation. The consumer price index in the 12 months ended in May 2019 rose at less than 2%! It seems remarkable that with unemployment rates at 3.7% (June 2019), wages, the most important determinant of inflation, are rising at only slightly above the consumer price index. Commodity prices, especially for oil and gas, have been weak. Domestic industrial utilization rates have remained stuck in the 75% to 80% range. It is likely the combination of globalization of highly efficient international supply chains, the Internet, the relentless drive of businesses to reduce costs, and the absence of pricing power, among other factors, has kept inflation in check.
The current expansion has been the longest in duration in the post-war period, yet also one of the weakest. Real GDP since 2009 has only increased around 22% compared to the last four expansions of the U.S. economy that averaged close to 40% from trough to peak. A drag on the economy has been personal consumption expenditures. Real wages in 10 years have risen by only 2.3%, diluting the contribution of higher employment.
Fortunately, investors have not been impacted by the lackluster economy. That is because over the past 10 years, the operating earnings of the S&P 500 companies increased an astonishing 167% while the S&P 500 Index rose 125%. The same forces that have restrained inflation — low real wage growth and low commodity prices — have enabled companies to maintain historically high operating margins. According to Bloomberg, operating margins of the S&P 500 Index companies were 12.7% in 2007, the year before the financial crisis, but recovered fully by 2011 and were reported at 13.2% in 2018.
Table 1: Selected Economic Forecasts
|Real GDP Growth|
|International Monetary Fund||2.2%||2.9%||2.3%||1.9%||1.7%|
|Congressional Budget Office||2.2%||2.9%||2.3%||1.7%||1.6%|
|Consumer Price Index (Personal Consumption Expenditures)|
|International Monetary Fund||2.1%||1.9%||2.1%||2.2%||2.0%|
|International Monetary Fund||4.4%||3.9%||3.6%||3.5%||3.6%|
|Government Deficit % GDP|
|Congressional Budget Office||-3.5%||-3.9%||-4.2%||-4.0%||-4.2%|
|International Monetary Fund||-3.5%||-3.9%||-4.2%||-4.0%||-4.0%|
|Federal Debt (Public Hands) % GDP|
|Congressional Budget Office||76.5%||77.8%||78.2%||79.5%||81.0%|
|International Monetary Fund||76.5%||77.8%||78.7%||79.7%||80.6%|
|Merchandise Trade Balance % GDP|
|International Monetary Fund||-4.2%||-4.3%||-4.2%||-4.5%||-4.6%|
Table 1 shows economic forecasts for the U.S. economy through 2021. We are struck by how little disagreement there is in the forecasts. The main takeaways are: real GDP will continue to grow slowly over the next two years; no recession is in store although the risks of a downturn have moderately increased; inflation will be muted; unemployment rates will continue at favorable levels; and the government deficit will remain below 5% of GDP, which is within a tolerable range. In short, the current environment should be extended and remain relatively stable.
Noise and Potential Disruption
It is axiomatic that a good investment environment is one that reflects stability and predictability. The actions of the Administration are posing significant challenges.
War with the Fed
First, the President threatened Fed Chairman Powell with demotion, claiming that the increases in Fed funds target rates and the gradual ending of quantitative easing are dragging down the economy. The President is wrong on his economics. Although over the past two years the Fed did raise the target rate for Fed Funds 175 basis points to the 2.25%-2.50% range, real GDP growth increased in 2018 from 2.2% to 2.9%. It seems unlikely that interest rates had any material impact on the economy. Moreover, at current interest rate levels, which are still low, the power of monetary policy is severely limited. The rate of economic growth is now decelerating. Recent forecasts of the Federal Open Market Committee members implied that the Fed is considering a reduction in Fed funds rates by as much as 50 basis points, hardly enough to provide any meaningful economic lift.
Unsettling Tariff Policy and Trade Disputes with China
President Trump regards the annual $800 billion merchandise trade deficit of the United States as the result of unfair treatment of U.S. goods by foreign countries. However, the selection of the specific goods on which to raise tariffs was baffling — the imports of solar panels, washing machines, steel, and aluminum will hardly impact the merchandise trade deficit. While the Administration praised the newly negotiated United-States-Mexico-Canada Agreement (USMCA) that replaces the North American Free Trade Agreement (NAFTA), most economists believe the net impact of the new agreement is negligible. And then a few days later, the Administration abruptly threatened a series of tariffs on Mexican goods unless Mexico addresses its southern border with Guatemala and halts the flow of immigrants into the United States. Mexico responded and the Administration backed off. But U.S. manufacturers that have operations in Mexico and supply chains that depend on Mexico were alarmed. More recently, the United States has threatened new tariffs on $25 billion of imported goods from the EU. Late last month, Trump issued a threat of tariffs against Vietnam. No one is quite sure where the United States is heading regarding new tariffs. The point is that the power to impose tariffs rests largely with the President and he seems to be using this power in a highly capricious, not policy-driven manner.
The most important trade negotiations are with China, which in 2018 accounted for close to 50% of our merchandise trade deficit. To the Administration’s credit, a principal thrust of U.S. trade policy relates to China’s bad behavior as reflected by its theft of intellectual property, forced transfers of know-how, competitive practices that violate the rules of the World Trade Organization, and even the dumping of certain products.
Bloomberg estimates that Chinese exposure to U.S. trade flows amounts to nearly 4% compared to only 1.3% for the United States. It is interesting to note that through April 2019, the merchandise trade deficit with China has declined 45% and the overall merchandise deficit is no longer growing. Jawboning and threats apparently are making a difference as companies are already seeking alternative sources of supply. We don’t believe either country wants a trade war. In time we expect them to settle their major differences. At the recent G20 meetings in Japan, U.S. tariff increases on Chinese goods were postponed, and new negotiations were scheduled.
However, the noise and confusion are unsettling. Chairman Powell in a recent speech noted that feedback from contacts in business and agriculture suggests that our trade policy “may have contributed to the drop in business confidence in some recent surveys and may be starting to show through the incoming data.” Over the long term, we think Christine Lagarde, the IMF Managing Director, is on target: “...for the global economy to actually function well, it needs to be able to rely on a more open, more stable, more transparent, more predictable, and rules-based international trade system.”
International Conflicts and the Potential for War
The investment community is nervous and for good reason. Highly respected Ian Bremmer, President of the Eurasia Group, noted in the firm’s annual report, “Top Risks 2019,” that
“the geopolitical environment is the most dangerous it’s been in decades....” However geopolitical cycles are slow-moving. It takes a long time to build a geopolitical order... multilateral institutions take decades to build.... Once in place, they’re sticky. And so barring bad luck (read: a sudden unforeseen crisis), it takes years, even decades to knock down a geopolitical order.”
Sadly, the United States is contributing to the erosion of the geopolitical order by withdrawing from treaties such as the Paris Agreement on climate change and the Iran nuclear deal, devaluing NATO, schmoozing with bad actors such as Kim Jong-un and Vladimir Putin, and so forth. The most important hot spots seem to be Iran, North Korea and the South China Sea. We have no deep insight into the risks these tensions represent but we believe that armed conflict will be avoided.
Corporate Earnings and Market Valuation
S&P 500 Index earnings have been on a tear. Last year, owing mainly to corporate tax rate reduction, earnings increased 21.8% from $124.51 to $151.60. Expectations are for earnings in 2019 to advance in the mid- to upper single-digit range to around $165. It should be noted that from 100 to 200 basis points relate to share buybacks, which continue at a high level.
Table 2: S&P 500 Index Levels, Earnings and Price/Earnings
|Current Price Earnings Ratios||2017||2018||2019||2020|
|S&P 500 Index (2019 as of June 30, 2019)||2,688||2,507||2,914||Earnings Estimate|
|S&P 500 Earnings (Actual 2017 & 2018, Estimated 2019)||$124.51||$151.60||164.93||High||Low|
|S&P 500 Price/Earnings (2019 Estimated as of June 30)||21.6||16.5||17.7|
|Forward Price Earnings Ratios|
|S&P 500 Index (June 30, 2019)||2,914|
|S&P 500 Earnings (Estimated 2020)||$184.82||$173.18|
|S&P 500 Price/Earnings (Based on June 30, 2019, S&P 500 Index)||15.8||16.8|
|Source: Standard & Poor’s|
At the end of last year, the market was selling at around 15.2x based on 2019 estimated earnings (2507/165). The 25-year average of the S&P 500 Index forward price earnings (P/E) is 16.2x. 67% of the time, the market's forward P/E ranged between 19.4x and 13.0x. The gain in the S&P 500 Index has raised the P/E multiple on current earnings to 17.7x. At this point we regard the S&P 500 Index as being fairly valued, but not having much potential for further appreciation. The June Bloomberg survey of investment strategists at major institutions indicated no gain in the S&P 500 Index from current levels for the balance of the year.
We have thought for a while that the decline in the cyclicality of the economy, the reduction in the incidence and the shallowness of recessions, our greater resilience to deal with financial crises, the generally lower fixed investment in business enterprises (capital-light businesses), the rise in free cash flow of which a meaningful proportion is allocated to dividends and repurchase of stock — all these factors justify higher valuations in the market. But as McKinsey recently noted, “The rise of China, India, and other emerging economies, the rapid spread of digital technologies, and growing challenges to globalization... are all roiling business, the economy and society.” Add to this the aging of our society, which imposes entitlement burdens and reduces the labor force; artificial intelligence, which could dislocate large swaths of our labor force; slower economic growth over the long term, which will also affect the growth of corporate profits; the long-term threat of income inequality in our society — all these factors suggest lower market valuations.
The past decade has been an unusual period in which financial assets have significantly outperformed the real economy, and no one should assume that this is a sustainable pattern that will continue over the long term. There is no guarantee that the strong market returns over the past decade will continue and, indeed, starting valuations make this unlikely. Notwithstanding our expectations for lower portfolio returns, we remain convinced that equities over the long term will outperform bonds and cash.
Stratigraphic Asset Management, Inc.
- The Bureau of Labor Statistics reported that the CPI advanced at an annual rate of 1.8% through May while the increase in real average weekly earnings advanced a whopping 1%.
- Operating earnings are expressed after taxes and received a very significant boost from the reduction in corporate tax rates and the repurchases of shares in part funded from repatriated capital from abroad.
- The probability of a recession has risen to around 30% according to the consensus of economists reported by Bloomberg. We believe that this estimate of risk is too high and not warranted by current economic conditions. But even if there were a recession, the likelihood is that it would be relatively shallow and short. Bear in mind that the financial crisis, which was especially damaging to capital markets in 2008 and 2009, resulted in a recession that lasted only two quarters!
- Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, June 2019.
- Bloomberg, Kennedy and Best, “Trump-Xi Summit at G-20...,” June 26, 2019.
- Bureau of Economic Analysis, U.S. International Trade in Goods and Services, April 2019.
- Jerome H. Powell. “Economic Outlook and Monetary Review,” Speech at the Council on Foreign Relations, New York, June 25, 2019.
- Transcript of Press Conference on the Conclusion of the 2019 Article IV Consultation with the United States, June 6, 2019.
- “Market Insights,” J.P. Morgan, as of March 31, 2019, page 5.
- McKinsey Global Institute, “Navigating a World of Disruption,” January 2019.