Financial markets 2019: Tariffs, earnings and interest rates
Associate Professor of Finance, Indiana University Division of Business, Indiana University–Purdue University Columbus
James and Virginia Cozad Professor of Finance, Kelley School of Business, Indiana University Bloomington
At the time of this writing, the stock market has just experienced one of the worst months in recent history. The S&P 500 fell 8 percent in October. Yet earnings are up in every sector and are projected to grow in 2019. Revenue is up and forecasted to be stronger. Businesses are investing more than ever. The private sector is one of the factors driving the GDP growth that politicians are bragging about. The market started the year worth $27.9 trillion and quickly added 6 percent in January. Then it fell 10 percent to a low in April, rose to a high of $30.3 trillion in September, and then lost $3.5 trillion in October. So the stock market spent the year gaining and losing $3 trillion. This is clearly due to two factors.
First, the White House decided to increase tariffs on goods with many of our trading partners. The increase is a small percentage of GDP. Furthermore, 37 percent of the revenue for firms in the S&P 500 comes from sales outside the United States. Yet the markets clearly believe the effect of tariffs will be large. The White House—which has been enabled by Congress—is persistent in challenging our trading partners and seeing a trade deficit with a country as them “taking advantage of us.”
A new round of taxes against goods from China (yes, “tariffs” are taxes) could occur as early as December and target the rest of the imports from China—about $257 billion worth. On October 29, the Dow Jones Industrial Average fell more than 100 points following the trade news, erasing a 350-point gain earlier in the session after a Bloomberg report surfaced, exposing a new round of tariffs. But on November 1, the Dow went up 200 points when the White House reported that talks with China are “going well.”
Second, interest rates have responded to the strong economic growth and the large and growing federal deficits. The demand for money has pushed rates higher. The 10-year Treasury rate is 3.15 percent versus 2.4 percent a year ago. Corporate bond rates are 7-8 percent, up from 5-6 percent a year ago. Unhelpfully, on September 26, the Federal Reserve raised their benchmark federal funds rate by another quarter of a percentage point, lifting it to a range of 2 to 2.25 percent. This is the third increase of the year and the Fed’s economic forecasts, along with the talk about a “neutral rate,” are signs that the end of the committee’s rate-raising campaign is nowhere in sight. Other interest rates have followed the federal funds rate. (Contrary to the assertions in the press, the Federal Reserve does not control interest rates. It only controls one rate and the others are set by the market.)
But the increased federal funds rate is part of Fed actions to reduce the rate of growth of the money supply. From 2000 to 2017, the growth of the nation’s money supply was 6.7 percent per year. Year-to-date, on an annualized basis, money supply is growing by 3.4 percent. This is almost half the longer-term growth rate. While savers can look forward to seeing higher yields, conditions look difficult for borrowers.
Currently, the yield curve has flattened considerably, although it has not inverted. The spread of Baa corporate bonds over the 10-year Treasury measured 198 bps as of October 25, 2018, with the 10-year Treasury measuring 3.14 percent.1 From this vantage point, there appears to be low risk on the horizon, given demand exists for lower-quality, investment-grade bonds at only moderate premiums. Figure 1 shows credit spreads widening in each of the last two recessions, with widening visually proportionate to the severity of the contraction.
Figure 1: Credit spreads over 20 years
Source: Federal Reserve Bank of St. Louis, Moody's Seasoned Baa Corporate Bond Yield Relative to Yield on 10-Year Treasury Constant Maturity [BAA10Y], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAA10Y
With this as a background, we turn to fundamentals. Stock prices are determined by the future stream of cash flows—driven by earnings—and the valuation of these cash flows (which is the present value using a discount rate reflecting risk). Typically, this is summarized by earnings forecasts and a valuation ratio, such as the price-earnings (P/E) ratio.
The positive fundamental factors for stock returns in 2019 are:
- Earnings growth: Analysts are forecasting earnings will increase 9.4 percent in 2019 for the S&P 500. Energy is predicted to grow 29 percent. Utilities is expected to be the worst sector with 4.2 percent growth. Sectors with above-average expected earnings are energy, industrials and consumer discretion.
- Revenue growth: Revenues for the S&P 500 are expected to rise 5.4 percent in 2019. The best sector, communication services, is expected to rise 9.8 percent, while the worst sector, materials, is predicted to rise 2.7 percent.
- Year-over-year earnings growth: From third quarter 2017 to third quarter 2018, there was a positive 24.9 percent growth for the S&P 500. The strongest sectors were energy (123.4 percent), financials (35.4 percent), communication services (30.3 percent) and materials (28.5 percent).
- Year-over-year revenue growth: There was a positive 8.5 percent growth for the S&P 500, led by the financial sector.
- Quarter 3 earnings and revenue “beats”: Of the companies in the S&P 500 that have reported earnings and revenues for the third quarter of 2018, 78 percent have reported earnings above the mean estimate of analysts (higher than the historical average of 69 percent) and 61 percent have reported revenues above the mean estimate (below the historical average of 66 percent).
- IPOs are strong: There have been 173 IPOs (as of October 15) that raised $45.7 billion. This is up 47 percent over this time last year and is three times as much as in 2016. The biggest sectors were biotech (where 55 IPOs raised $6.8 billion) and technology (where 38 offers raised $15 billion).
- Price expectations by analysts: Stock ratings for the S&P 500 are 53.3 percent buy, 41.2 percent hold and 5.5 percent sell. The energy sector leads with 63.3 percent buys while consumer staples had the lowest fraction of buys at 41 percent. Note that analysts expect earnings to be lower in real estate and utilities than consumer staples but still are more negative on consumer staples.
- It is cheaper to buy $1 of earnings: As of November 2, 2018, the 12-month forward P/E ratio for the S&P 500 was 15.6. (This is current price divided by forecasted earnings. Multpl.com shows the current S&P 500 P/E ratio is 22.2.) The P/E ratio is below the five-year average (16.4) but above the 10-year average of 14.5.
Some headwinds for the market include the following:
- The market is not rewarding companies that beat analysts’ expectations for earnings: During the recovery, for companies who beat expectations (sometimes called “positive EPS surprises”), stocks experienced a 1.0 percent price increase during the four-day window surrounding earnings reports, two days before and after releases. In 2018, even though the percentage of firms that beat analyst estimates are about average, the market response is only 0.2 percent.
- The market is punishing companies that report earnings less than analysts’ expectations: For the 14 percent of firms that had negative surprises, their four-day return was -3.8 percent versus the five-year average of -2.5 percent.
- The Schiller cyclically adjusted P/E ratio (CAPE) is currently at 30.0, which is near one of its highest measurements, the other two occurring in (a) 1929 just prior to “Black Tuesday” when the Schiller measure was also about 30, and (b) in the latter part of 1999, just prior to the dot.com crash, when many publicly traded firms led by the burgeoning technology industry were yet to create any positive earnings. In 2019, we expect most companies to continue to produce positive earnings over the coming year, which should help bring the Schiller P/E ratio measure for the market back into line, somewhere south of 30, or even better, south of 25 by the end of next year. At least, that certainly is our hope …
- Stock repurchases over dividends: Analysts estimate stock buybacks within firms of the S&P 500 to total between $800 billion and $1 trillion by the end of 2018. Opting to repurchase shares rather than paying more dividends may be interpreted as a bearish sign.
- Volatility levels: The VIX index measures volatility in the market by looking at S&P 500 options prices. It was flat and low in 2017 but has been high and volatile in 2018.
- Budget deficits: The projected budget deficit for 2018 by the Congressional Budget Office (CBO) is $811 billion. This means that federal expenditures were $811 billion more than federal revenue. The deficit is about 3.9 percent of GDP, up from 3.5 percent of GDP in 2017.
- U.S. debt: The deficit has caused the expansion of the national debt since the end of 2008. This is the largest expansion since World War II. The total debt (held by the public) is $15.7 trillion, which is 78 percent of GDP. This ratio was 76 percent in 2017 and is expected to grow to 88 percent in five years with trillion-dollar deficits starting in two years. In five years, the CBO forecasts that the interest paid on the federal debt will be larger than the defense budget. If interest rates rise to their historical average levels, the budgetary impact will be dramatic. Increasing the average rate by 1 percent will trigger an additional $140 billion in federal spending. This will require reduced spending in other areas, increased taxes or both.
- Public debt is increasing interest rates: The growth in federal debt has put upward pressure on interest rates. The federal debt and economic growth has raised interest rates, which in turn has put the stock market under pressure.
- The U.S. still faces a huge funding deficit in Social Security and Medicare payments. The present value shortfall is about $62 trillion. This is equivalent to $206,000 per person or $825,000 per U.S. household. These problems are not insurmountable, but they do require common sense and bipartisan leadership—something that appears to be in short supply in Washington, D.C.
- International risks: China’s economy has slowed to below 7 percent, and the U.S. is actively engaged in international trade negotiations, including changes to tariff policies. It is not clear how these negotiations will end up and what effect they will have on continued international trade, U.S. companies and the consumer marketplace. While it is conceivable the U.S. could ultimately gain trading advantages with certain countries and yield improved positioning overall in the longer term, downside risk is evident in the short term and longer term.
Looking forward to 2019, the positives outweigh the negatives for the market. The economy is robust, and we think GDP growth will be over 3 percent in 2019 with inflation around 2.5 percent. Earnings are likely to stay strong and should overcome the two headwinds of interest rates and trade wars.
In this environment, we expect the return to equities to be positive, but again below the 7.5 percent average return over the past 50 years. We think that Treasury bonds will show increases beyond their current level, and we think there are material long-term inflation risks that could make long-term bonds unattractive. Investors should stick to short-term bonds to reduce their exposure to higher interest rates.
- Federal Reserve Bank of St. Louis, Moody's Seasoned Baa Corporate Bond Yield Relative to Yield on 10-Year Treasury Constant Maturity [BAA10Y], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAA10Y#0, October 29, 2018.