Q4 2018 Market Update: The Start Of A New Crisis?

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A speculator is a man who observes the future, and acts before it occurs.
— Bernard Baruch

The stock market lost nearly 2 trillion during the October sell-off, with the major averages hitting multi-month lows. The sell-off was induced by cautious earnings guidance, concern over China’s economic outlook, as well as higher borrowing costs for businesses due to rising interest rates. It's a replay of what happened in the first-quarter reporting season, when firms reporting solid financial performance sold off upon the announcement of earnings reports. As I stated in U.S.- China trade wars: Could it get any uglier? “The market conditions that led to February’s spike in the VIX (CBOE Volatility Index) — rising rates, less liquidity, and hedge funds being caught wrong-footed — are still there.”

In Brief

  • The big question on investors’ minds: How durable is global growth over the next several years?

  • S&P 500 companies are seeing the worst price reaction to positive EPS surprises since Q2 2011. According to John Butters of Fact Set, October 28, 2018.

  • Q3 2018 may likely mark the peak in double digit earnings growth as the effects of tax cuts and regulatory rollbacks are set to wane, but it’s not peak earnings — economic output is still growing.

 

The U.S. Stock Market: Profit margins at risk?

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As they have done throughout 2018, companies are reporting mostly good financial results for the third quarter. The October sudden flare-up of selling pressure was fueled, in part, by below-consensus earnings guidance from high profile companies. During this reporting season, CEO’s have been talking about the challenges they face with rising production costs and relatively new tariffs. This only served to increase investors’ growing concerns about a looming recession. Recent company comments revealed fears that the U. S. - China trade wars are leading to business uncertainty as U.S. multinationals’ lower forward earnings guidance. The hardest hit sector was technology. The beloved F.A.N.G. titans (Facebook, Amazon, Netflix, and Google) were clobbered in October, perhaps signaling a shift in market leadership for the most crowded trade in the equity universe. 

While it looks to be the end of double-digit earnings per share gains due to the Trump tax cuts, the S&P 500 is still expected to yield a 9.3% gain in 2019. Peak earnings growth implies that earnings will continue to grow, but at a slower pace. It does not mean earnings have peaked.

Note: The UBS daily corporate liquidity signal shows that the combination of buybacks and dividends will more than triple over the coming weeks, "rising to a weekly pace of $48 billion by mid-November as earnings are announced and blackouts end."

The U.S. Bond market

Investors are pouring their money into bonds and it’s understandable given recent market jitters. At the time of this writing, the 2-year Treasury bond is yielding almost 2.9% for the first time in years. The big question on the minds of investors is whether or not the economy can withstand a string of new rate hikes. In January’s market views on 2018, I stated:

“Much of the Fed's policy this year will be influenced by what other central banks decide. Given that both the European Central Bank and the Bank of Japan continue to be plagued by low inflation, the Fed will likely tighten three times in 2018 with a median estimate for federal funds rate at 2.1%. The pace of “quantitative tightening” and the market's reaction will be an important factor not only for credit markets but also for equity markets in 2018.” 

The data is telling the Fed to rethink their “auto-pilot” rate hiking agenda. While the market anticipates a fourth hike in December, I think the Federal Reserve Bank will hit the pause button on its path back to “normal” monetary policy given the global economic environment. Thus, I believe the flattening yield curve should begin to steepen again by year-end.

Cambridge Insight: Junk bond yields have not widened at this juncture, signaling default concerns, as they did in 2007 prior to the Great Recession of 2008.

The Bottom Line: 

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The market bloodletting during October represents the readjustment in earnings over the coming year due to challenging year-on-year earnings per share comparisons. Additionally, dark clouds are forming over the global economy due to geopolitical uncertainty — Brexit is increasingly looking like a disaster, and the trade war with China seems set to worsen. Add to this list concerns over midterm U.S. elections, and there’s a very real prospect that over the next 12 months — the world’s two largest economies — the United States and China, could slow.

The Trump administration is engineering significant changes at home and abroad that represent sharp revisions of direction from traditional American positions. Chicago billionaire real estate investor, Sam Zell, recently commented that government regulators seem to have adopted a more business friendly approach, and as such, investors are more willing to take on risk. On trade, President Trump's approach to negotiations has produced favorable new trade agreements with Canada, Mexico, and South Korea. Hopefully, China follows South Korea’s example and agrees to cut their large trade surplus with the U.S. and rebalance a relationship that has served them so well.

The current market environment calls for a cautious approach. However, there are a number of “turnaround triggers” that could help boost the market and my confidence over the next year: meaningful progress in the U.S.- China trade war and the Federal Reserve reversing its intentions to continue raising interest rates.

Lastly, regardless of midterm election outcomes, the markets have historically experienced a 7% post-election surge. However, during the Trump era, old playbooks don’t apply. The latest decline ultimately should not compromise the integrity of the bull market. A fundamental reason for stating this is that corporate earnings growth remains on a positive trajectory given the current administration’s market friendly policies. Jamie Dimon, CEO of JP Morgan, said in a media conference call following his bank's recent earnings report, “The economy is still very strong, and that's across wages, job creation, capital expenditure, consumer credit; it's pretty broad-based, and it's not going to be diminished immediately." I’ll take Jamie Dimon at his word.



SOURCES:
Wall Street Journal Online; Bloomberg News; Investor’s Business Daily; Forbes.com; CNBC News; Reuters News;

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