This time last year, high long rates and the trade war kicked off what turned out to be a 20% correction for the S&P 500. The move took the market back to levels signalling that the fundamentals for 2019 were not as great as were once thought; as if by magic, analysts started pegging back their US earnings estimates for this year. Having started with a 10% gain, they are now looking at no change at best. The same goes for world GDP growth, once forecast at 3.2% and now estimated at 2.8% with more downward revisions on the way. The market was right about a slowdown, in other words, but failed to take account of interest rates. Bond yields have slumped to all-time lows, which has spurred equity prices higher even without higher profits. Having looked likely at one point, recession has been avoided.
With equities some 20% better than their lows of last year, investors now seem to be in two minds where the S&P 500 can go from here. It is hard to say whether we are simply passing through a temporary deceleration in activity or verging on recession once again. The trade war is the main factor behind the uncertainty, and the failure to find a solution could worsen the outlook for activity. FedEx’s share price is a good proxy for sentiment on world trade, and it has halved. The IT sector is also a major casualty of the fallout with China. The outlook for world growth in 2020 is poorer than that for 2019 and includes projections of just 1.7% for the USA and 1% for Europe excluding any Brexit effect. US equities are just 2% off their record high and make no allowance for anything worse. Signals from companies are not very encouraging: consensus analysts are pencilling a 10% EPS gain next year, but the latest announcements point to 6% and our own top-down scenario assumes 8%.
Recent data releases for the American economy are mixed. The good news includes an upturn in construction, buoyant consumer confidence and a tight labour market offering higher wages. But the trade war is driving manufacturing PMIs towards or below levels dividing expanding from contracting activity more or less worldwide.
The US yield curve is still inverted, although somewhat less so since the Fed’s rate cut. Negative interest rates around the world raise questions about how central banks propose to react to any fresh downturn in activity. We believe the only weapon they have left is ‘helicopter money’, which has the advantage of putting money directly into consumers’ pockets.
Investors are likely to be focused over the coming months on asset values and their portfolios’ capacity to generate cash flow. Our S&P 500 valuation model gives us a theoretical year-end objective of 2,897 points with a 30-year yield of 2.13%, compared with last week’s close at 2,962 points. The recent wave of IPOs highlights pressure on existing valuations, and the market is horribly exposed to new twists in the trade war and a no-deal Brexit. Optimists will be banking on agreement between Donald Trump and China ahead of the presidential election campaign and a reasonable Brexit solution.
In the euro zone, negative interest rates have created a real estate bubble. Equity valuations are not as high as they are on Wall Street. We continue to recommend equity weights below investors’ benchmarks (in our case, 35% rather than 40%). We would also be buying the S&P 500 at 2,740 points, which would correspond to a ‘sharp slowdown’ economic scenario.
