By Mark Govoni
In light of recent volatility, we wanted to get our regular quarterly letter out early. Since reaching its October peak at about 2940 the S&P has made repeated trips down to the 2600 level. Likewise, bond rates peaked in early October at around a 3.25% only to recede in dramatic fashion to 2.85% some sixty days later. Clearly, the causes of this volatility are numerous and open to debate, yet all can be summed up in one word: UNCERTAINTY. It is both the nature of this uncertainty and its likely outcome which we will discuss briefly.
Our belief is that we are currently faced with two types of uncertainty, the self-inflicted variety as well as the cyclic variety. The self-inflicted uncertainty can be managed. The cyclic uncertainty, we would argue, is not fully understood.
- Hostile Federal Reserve – up until this week the Federal Reserve has been clear in outlining their intent to move rates towards the ‘neutral’ level. This is the level at which rates are neither helpful nor a hinderance to economic growth. This mysterious neutral rate exists nowhere but in the minds of each individual Fed Governor. This level, through the Feds reporting, is somewhere between 2.5% and 3.5%. The seeming inevitability of this normalization process has led to great uncertainty in the markets. One only needs to look at the two-month progression of 10-year rates to understand this confusion.
Furthermore, Jay Powell panicked markets with his “go too far” comments in October. It is unclear to us if this was simply a rookie mistake or an intended signal to the markets. In any event, after witnessing a clear deterioration in housing and the auto market the Fed has had to calm the situation by signaling that they are not hell bent on causing a recession. Bottom line – the Fed has renewed its commitment to being data dependent rather than rate level dependent. That’s as much as we can ask for. We think the Fed will have to raise rates in December, but we would be very surprised if they do so again before late in 2019.
- Trade – It seems the administration has homed in on what it really wants out of its trade spat with the Chinese. The early talk of trade deficits has moved towards more serious structural complaints which cannot be resolved quickly over a cup of tea. The litany of complaints surrounding Chinese practices goes back 30 years and to think this will be solved quickly is naïve.
The problem with the current situation is the uncertainty faced by decision makers. This uncertainty compels CEO’s to keep a tight grip on their investment dollars. Reduced capital spending equals increased economic concern. We believe that the way out of this comes through a series of trade deals whereby China buys more American goods over the near term leaving the stickier issues for a future date. We are hopeful that the administration will continue to press for increased access, reduced technology transfer demands, and an end to corporate espionage. We fear this process will span multiple administrations. For now, we only need a short-term resolution.
Peak Earnings – To those who wish to point out that we may well have reached peak earning we say, ‘no kidding’. It’s not possible to grow earnings at 24% annually for any amount of time. Importantly, Peak Earnings does not mean negative earnings. Yes, the rate of change will be less, but it won’t be negative for 2019. The market is working through the process of deciding what it should pay for the new earnings growth environment. Current estimates are for earnings growth of 8.5% or $176+ in 2019 (FactSet). We believe this may moderate over time, but at $176 we are trading at less than 15 X next year earnings, a level which should put a bit of a floor underneath the stock prices.
Peak Margins- It may well be that profit margins peaked in 2018 at a 25 year high of 12% operating. Just like earnings growth we would not dispute this very real and likely possibility. But that doesn’t mean margins are going negative. Again, the absolute rate will have to moderate but there will be earnings next year and margins will be positive.
What does it mean?
The economy is slowing. We have known this for some time. A slowing economy, however, is not the same as a recessionary economy. Once again, the rate of change is less but growth persists. What we are seeing is a change in market sentiment brought about by policy. A partial resolution to trade tensions and a Federal Reserve that moves much slower will help bring market action back in line with economic data.
It seems we entered 2018 unprepared for the events which have transpired. It now appears that we are entering 2019 over- prepared. Market sentiment is now discounting the worst case in every possible scenario. We believe that a chance of a recession in 2019 is minimal. We agree that we are at an inflection point and the rate of both earnings and economic growth is slowing. We further realize that markets can become very volatile as investors reach to make sense of these changes. If, however, we can resolve some of the self-inflicted uncertainty markets will begin to calm themselves.
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