Equities have stumbled this month, as weak economic data has revived recession fears. This comes after central banks’ dovish pivot fueled significant multiple expansion. Where to now? We see limited additional monetary easing ahead. This means earnings will be key for further U.S. equity gains. Third-quarter earnings season may offer some limited support as the macro backdrop worsens. But we see easier financial conditions helping growth and earnings over 6-12 months.
Multiple expansion – rising price-to-earnings ratios – has been the principal contributor to global equity performance in 2019. Earnings growth has only been a modest contributor in the U.S. – and detracted in other regions. See the chart above. Behind the multiple expansion, in our view: monetary easing. Lower rates are typically reflected in higher price-to-earnings ratios. The Federal Reserve has cut rates twice this year to cushion the economy. We do expect the Fed to cut further, yet we believe markets may be pricing in too much additional easing in the year ahead. This points to limited scope for further multiple expansion and increases the importance of earnings growth in driving further gains.
U.S. stocks have outperformed in 2019 – even as analysts’ earnings expectations have drastically fallen. A year ago, S&P 500 earnings were expected to grow roughly 10% this year; that number has dwindled to around 2%. Expectations point to a modest year-on-year contraction in third-quarter U.S. earnings. This partly reflects a high bar set in 2018, when corporations enjoyed a one-time boost to earnings from U.S. corporate tax cuts. Companies across most sectors have been guiding expectations lower as reporting nears. The lowered expectations mean the weak earnings season may offer some upside surprises; quarterly results have beaten the conservative guidance that prevailed prior to each quarter this year.
Yet renewed growth concerns and lingering trade uncertainty cloud the near-term profit and market outlook. Persistent uncertainty from the protectionist push is weighing on corporate confidence and slowing business spending, as we write in the Q4 update to our 2019 Global investment outlook. In the near term we see potential for further bouts of market volatility, as fallout from the unresolved trade war is reflected in weak economic data. We do not expect significantly looser U.S. monetary policy on the horizon in response. Complicating the case for further Fed easing: Supply chain disruptions could foster mildly higher inflation, even as growth slows. The trade war fallout could also weigh on a rosy corporate profit outlook for 2020 – adding to the pressures from declining profit margins typical of the late stage of a business cycle.
The longer horizon
The overall outlook looks better on a 6-12 month horizon. We see a trough in U.S. economic growth, as the global monetary stimulus delivered to date feeds into the economy. This should boost companies’ top-line growth – at the late stage in the economic cycle when U.S. equities have historically delivered above-average returns. Against this backdrop, we maintain our moderately pro-risk stance over the longer horizon, even as additional volatility could be with us over the shorter term. We prefer U.S. stocks for their quality bias, higher return on equity and lower exposure than other equity markets to manufacturing and industrial production weakness. We also see expectations of low-teens earnings growth in 2020 for regions such as emerging markets as much less realistic. Through a factor lens, we prefer min vol and quality for their defensive properties. Bottom line: We remain overweight U.S. stocks as third-quarter earnings season kicks off.