The slightly heady mood imparted by better news on China, an almost-done Brexit deal and very low interest rates left the S&P 500 to 3,023 points at last Frida’s close, just 3 points off its high.
In the meantime, our own valuation for this market has eased from 2,865 to 2,834 points, indicating that the index is trading some 7.7% above where it should be. The model’s divergence from the market reflects an uptick in US interest rates and continuing downward revisions to estimates of corporate earnings. Expectations of a final Fed rate cut this week ahead of years of no change – barring changes in the economic data – have ensured a steeper US curve. The reappearance of inflation could be one such change, as evident in the CPI series. The catch is that the Fed pays attention to the PCE deflator, which is more subdued.
American earnings per share will be at best unchanged in 2019. Ongoing Q3 announcements show lower profits than this time last year, and negative surprises outweigh positive ones. Problems at Boeing and among IT firms exposed to China are all too evident. Microsoft is the exception, pressing on with its already impressive trajectory and becoming the market’s most highly-capitalised name in the process. Elsewhere, Q4 guidance has been cut sharply and estimates for the first quarters of next year are down as well. Analysts are undaunted, however, even pencilling in .8 billion in profits for Boeing in 2020. That would be much higher than even the company’s record profit in 2018 and means that it accounts for 9% of the expected increase in index profits next year all on its own. Gafam may be under attack from all sides on the grounds that they abuse their near-monopoly status, but their earnings estimates are still brilliant and tech-related IPOs such as Uber have turned out to be flops.
Until the next technological revolution comes along, profits are likely to be at their cycle highs. The combination of stagnating profits and rising share prices has boosted the US market’s PERs to 18.7x 2019 and 17.1x 2020. A 31% drop in M&A volume in the presence of very low interest rates also suggests that potential targets are overpriced. That said, market valuation is a far from exact science and perceptions could change radically if the current slowdown in growth proves temporary, for example, if the Fed injects liquidity yet again or if a drop in volatility reduces the risk premium investors demand from holding equities.
Economic growth forecasts are also fading around the world, both for this year and 2020. We are now at just under 2.8% for 2019 and at 2.67% for 2020. The standout number for next year is a poor 1.7% for the USA; the euro zone is down to 1.15% and Germany at only 0.8%, while France is holding up slightly better at 1.2%. Chinese growth is slipping below the symbolic 6% barrier. Manufacturing and services PMIs are trending lower, and Americans are buying the growth they have with credit. Federal government debt is up to 100% of GDP; the deficit is at 5% of GDP.
Slower growth is highlighting glaring inequalities in many countries, prompting popular unrest. France has its ‘yellow jackets’ movement, and people are taking to the streets from Chile to Lebanon. Worsening inequalities in the USA explain the emergence of left-wing presidential candidates such as Bernie Sanders and renewed talk of wealth taxation. US wages are increasing by just 3% a year at the moment, yet capital has appreciated by an annual average 6.3% over the past 20 years. One result has been poor economic growth, as purchasing power has been concentrated among already wealthy households rather than the middle class consumers that have a high propensity to spend it.
We still recommend underweighting benchmark equity allocations (35% versus a 40% benchmark, in our case, although the original 35% has become 40% with the market’s rally). According to our model, European equities are at theoretical fair value.
