Watching US earnings and ignoring noise
Every good plot has a single protagonist. And the story of US stock valuations in 2019 is no different. While noise around politics and trade will compete for investors’ attention, the narrative will be driven by corporate earnings growth.
The narrative, as we see it, goes like this:
- An unusual set of circumstances boosted year-on-year growth in earnings per share to an average of around 24 per cent in the first three quarters of 2018. The cocktail of lower corporate taxes, a reduced regulatory burden, and a growing economy helped the US market outperform those of other countries.
- These factors are one-offs and we expect their impact on earnings growth to fade in 2019. US earnings will grow but at a reduced pace, more in line with the performance of the real economy.
- If we assume a macro-economic growth rate of around 3 to 4 per cent, inflation of around 2 per cent and a share buyback level of around 3 per cent, the number to watch should be in the high single figures. This will bring the US in line with the rest of the world, where we see EPS growth converging at around 8 per cent.
- Companies may well start to see headwinds, such as rising cost inflation, intensifying in 2019. Labour-intensive sectors are the ones most exposed, and we will be closely watching the extent to which freight cost inflation and increasing wage costs are borne by consumers. We see a risk that companies will have to absorb some of this, pressuring margins.
This suggests the US market is nearing the end of the cycle, but our account is more nuanced.
While some sectors, especially consumer-driven industries such as autos, are getting close, others have some way to travel. Companies are mid-way through a $1 trillion capital expenditure cycle, one of the biggest since the 1960s and one that includes a heavy element of software and hardware spending. Sectors such as technology or business services that will benefit from increased levels of industrial investment can be expected to do well in 2019.
Source: Fidelity International, November 2018
The debt threat
The biggest threat to equities is debt. The 10-year quantitative easing experiment, coupled with a debt-fuelled boom in China, has left the world with a big tab to pay.
Central banks lowered the cost of debt funding in response to the global financial crisis in 2008, and there is a natural limit to how far and how fast they can normalise it. Given the sheer amount of debt in the global economy, a full return within a few years to the aggregate interest rate of last cycle, around 4.5 per cent, would be unaffordable.
While the global aggregate interest rate increased from 1.2 per cent to 2.2 per cent over the last two years, it is close to hitting a new top, which we put at around 2.5 per cent. Going further than this would risk triggering a new financial crisis, something no central bank is willing to do.
Problems in the debt market have the potential spread to other parts of the financial system. This is why we’re paying attention to the Italian bond market and the Chinese corporate bond market.
We are more concerned about China than we are about Italy. While the Italian bond market is the biggest in Europe, it is largely in the hands of domestic investors, who think long term and don’t panic in periods of market volatility.
The Chinese market is less mature. It is experiencing its first ever credit cycle, marked by a first wave of defaults. Chinese policymakers have a lot of tools available to them to stimulate the economy in response but it remains to be seen how investors react. They may be too concerned by what they see in the debt market to reinvest in corporate bonds.
While we expect Chinese policymakers to succesfully lead the economy through the credit cycle, they will have to do so without stimulating debt growth any further. Absolute levels are already high. As such, we are watching closely for signs that this process derails.
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