By Wasif Latif
Portfolio Manager, Head of Global Multi-Assets
U.S. market turbulence has picked up dramatically of late. The CBOE’s VIX, which measures stock volatility expectations, is up 70 percent in the past month, and over the past couple of weeks we’ve experienced a number of wide day-to-day price moves within the Standard & Poor’s 500. Bond prices (and thus yields) have also seen some sizable ups and downs.
Several key macro reasons are being offered for the mood swings, among them a slowing global economy, increasing trade tensions and rising interest rates. At the market level, there’s also concern that earnings growth for U.S. shares may be peaking.
As yet, there are few solid data points, so it’s hard to draw much of a conclusion as to whether what we are seeing now are the early days of a prolonged trend, or just another temporary bout of nerves that will soon pass, as they did back in February and again in March.
We are still early in third-quarter earnings season, and how the numbers come in relative to analyst forecasts may tell us more about whether the current turmoil is fleeting or long-lasting.
3Q expectations are high and so far the S&P 500 is beating them. The latest tabulations by the financial data firm FactSet as of October 19 show a 19.5 percent earnings growth rate and a 7.4 percent revenue growth rate, both of which are up from the consensus from a week earlier.
Surprisingly strong 3Q reports from the nation’s biggest banks are being credited with the most recent bump-up in the S&P’s earnings growth estimates. The October 19 FactSet report states that positive earnings growth and revenue growth is expected for all 11 sectors of the S&P 500 relative to the same period in 2017, with most sectors anticipating double-digit earnings growth.
Along with lower corporate taxes, higher interest rates have been helping the banks and other financials, and despite growing pressure from the president, the Federal Reserve will almost certainly press on with another short-term interest rate hike before year end –the fourth such increase in 2018 and the ninth since the current monetary tightening cycle began in late 2015.
The Fed has said it will keep raising until it sees evidence that higher rates are hurting the U.S. economy. The risk built into that approach, of course, is that the economic evidence reveals itself too late and we end up with an overshoot.
We’re looking past the likely rate bump in December to try to gauge what to expect next year. The Fed’s latest dot plot suggests up to three rate increases in 2019 – absent a serious inflation spike, we have a hard time seeing a reason for such an aggressive pace.
The Fed has indicated that it is less concerned about supporting asset markets than it was when the U.S. economy was on a less stable footing. The underlying assumption is that the economy is strong enough to withstand more market volatility.
It’s true that the U.S. economy is cruising along – GDP growth is at its highest in a decade, unemployment and inflation are ultra-low, and robust earnings are supporting stock prices (though not without occasional volatility flare-ups).
We think, however, that the U.S. is close to or even in the later stages of the current economic cycle. This is not to say we see a recession or a bear market lurking around the next corner, but we believe optimism attached to current U.S. conditions may be a little excessive.
U.S. stock valuations are now among their highest levels ever, and price is the strongest determinant of future returns. This increased risk in large part explains the current U.S. stock underweight in our asset-allocation portfolios.
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