By Mike Pyle, Elga Bartsch, Kurt Reiman, Beata Harasim
Earnings will be key for further U.S. equity gains. Third-quarter earnings season may offer some limited support to U.S. stocks in the near term, as the macro backdrop worsens and a growth rebound is months away. But we see easier financial conditions helping growth and earnings over 6-12 months.
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.
Chart of the week
Equity sources of total return in 2019
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream and MSCI, October 2019. Notes: The bars show the breakdown of each market’s return year to date into dividends, earnings and multiples. The dots show each market’s total return over the same period. Earnings refers to changes in 12-month forward I/B/E/S earnings estimates. Multiples refers to multiple expansion (or contraction) – the change in the 12 month forward price-to-earnings ratio. The indexes used are MSCI indexes representing each market. Returns are in local currency except World, Asia ex-Japan and EM returns, which are in U.S. dollars.
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 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 (EMs) 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.
Assets in review
Selected asset performance, 2019 year-to-date and range
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, October 2019. Notes: The dots show total returns of asset classes in local currencies. Exceptions are emerging market (EM), high yield and global corporate investment grade (IG), which are denominated in U.S. dollars. Indexes or prices used: spot Brent crude, MSCI USA Index, DXY, MSCI Europe Index, Bank of America Merrill Lynch Global Broad Corporate Index, Bank of America Merrill Lynch Global High Yield Index, Datastream 10-year benchmark government bond (U.S. and Italy), MSCI Emerging Markets Index, spot gold and J.P. Morgan EMBI index.
Signs that the drag on economic activity from the global protectionist push is spreading beyond the manufacturing sector have revived concerns about the growth backdrop, weighing on risk assets. Major central banks have taken a dovish stance – the Fed has cut rates in line with market expectations, following the European Central Bank’s broad stimulus package. Yet we see limits to how much monetary easing can be delivered in the near term. Monetary policy is no cure for the weaker growth and firmer inflation pressures that may result from sustained trade tensions.
Oct. 7 through Oct. 11 – U.S. and China trade talks are slated to resume, as the China delegation returns to the U.S. We see some possibility of a truce, but a comprehensive trade deal remains unlikely.
Oct. 10 and Oct. 11 – We see the core inflation component of the September U.S. Consumer Price Index (Oct. 10) holding close to or above the Fed’s target. The University of Michigan Consumer Sentiment Index (Oct. 11) will provide a signpost of whether a strong consumer can continue to offset manufacturing weakness. We expect to see ongoing consumer resilience.
Asset Class Views
|U.S.||A supportive policy mix and the prospect of an extended cycle underpin our positive view. Valuations still appear reasonable against this backdrop. From a factor perspective we like min-vol and quality, which have historically tended to perform well during economic slowdowns.|
|Europe||We have upgraded European equities to neutral. We find European risk assets modestly overpriced versus the macro backdrop, yet the dovish shift by the European Central Bank (ECB) should provide an offset. Trade disputes, a slowing China and political risks are key challenges.|
|Japan||We have downgraded Japanese equities to underweight. We believe they are particularly vulnerable to a Chinese slowdown with a Bank of Japan that is still accommodative but policy-constrained. Other challenges include slowing global growth and an upcoming consumption tax increase.|
|EM||We have downgraded EM equities to neutral amid what we see as overly optimistic market expectations for Chinese stimulus. We see the greatest opportunities in Latin America, such as in Mexico and Brazil, where valuations are attractive and the macro backdrop is stable. An accommodative Fed offers support across the board, particularly for EM countries with large external debt loads.|
|Asia ex Japan||We have downgraded Asia ex-Japan equities to underweight due to the region’s China exposure. A worse-than-expected Chinese slowdown or disruptions in global trade would pose downside risks. We prefer to take risk in the region’s debt instruments instead.|
|U.S. government bonds||We remain underweight U.S. Treasuries. We do expect the Fed to cut rates by a further quarter percentage point this year. Yet market expectations of Fed easing look excessive to us. This, coupled with the flatness of the yield curve, leaves us cautious on Treasury valuations. We still see long-term government bonds as an effective ballast against risk asset selloffs.|
|U.S. municipals||Favorable supply-demand dynamics and improved fundamentals are supportive. The tax overhaul has made munis’ tax-exempt status more attractive. Yet muni valuations are on the high side, and the asset class may be due for a breather after a 10-month stretch of positive performance.|
|U.S. credit||We are neutral on U.S. credit after strong performance in the first half of 2019 sent yields to two-year lows. Easier monetary policy that may prolong this cycle, constrained new issuance and conservative corporate behavior support credit markets. High-yield and investment-grade credit remain key part of our income thesis.|
|European sovereigns||The resumption of asset purchases by the ECB supports our overweight, particularly in non-core markets. A relatively steep yield curve – particularly in these countries – is a plus for euro area investors. Yields look attractive for hedged U.S. dollar-based investors thanks to the hefty U.S.-euro interest rate differential.|
|European credit||Renewed ECB purchases of corporate debt and a “lower for even longer” rate shift are supportive. European banks are much better capitalized after years of balance sheet repair. Even with tighter spreads, credit should offer attractive income to both European investors and global investors on a currency-hedged basis.|
|EM debt||We like EM bonds for their income potential. The Fed’s dovish shift has spurred local rates to rally and helped local currencies recover versus the U.S. dollar. We see local-currency markets having room to run and prefer them over hard-currency markets. We see opportunities in Latin America (with little contagion from Argentina’s woes) and in countries not directly exposed to U.S.-China tensions.|
|Asia fixed income||The dovish pivot by the Fed and ECB gives Asian central banks room to ease. Currency stability is another positive. Valuations have become richer after a strong rally, however, and we see geopolitical risks increasing . We have reduced overall risk and moved up in quality across credit as a result.|
Notes: Views are from a U.S. dollar perspective over a 6-12 months horizon.
This post originally appeared on the BlackRock blog.