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Michael Cembalest discusses his latest Eye on the Market, The Late Show. He considers why despite strong US earnings growth and global expansion, equity markets remain flattish in 2018.


/ 09:53
Michael Cembalest

Just got back from a trip to see clients in DC and Baltimore. And they were pretty surprised to see flattish markets despite some really eye-poppingly impressive new eyes and profits. With 60% or 70% of SNP companies reporting so far the results are pretty stellar. Around 80% of companies are beating estimates. And it looks like we’re going to end up with earnings and EPS growth of something north of 20%. Only 7% or so is attributed to the tax cuts. So this is a very impressive earnings quarter. And the capital spending is up 20% versus last year. Partially a reflection of the redeployment of off shore cash that is now subject to a one-time repatriation tax. So if you put together strong profits, some of the highest profit margins in twenty or thirty years and some pretty decent capital spending numbers, everything related to the corporate sector looks pretty good.

Nevertheless we had a feeling that in our outlook this year, we wrote about the fact that we expected a volatile, single digit year. Despite all this fantastic news on profits and that there were two main reasons for that. One of which being central bank policy, monetary policy withdrawal. And the second being the White House. We talked a lot about white house related issues and recent Eye on the Market. So let me focus just for a couple of minutes on why we were concerned about what we called the decline in western centralization. And so if you remember the Eye of the Market outlook, it had this big punch bowl of people sailing and skiing and water skiing, and surfing on it and a little hand is coming out to turn on this spigot. The spigot that drains liquidity from the system has been turned on the United States.

So the Fed has begun its journey and J.P. Morgan Economic Research, which is part of the Investment Bank, believes that the fed will hike 6-7 more times by the end of 2019. I’m generally in agreement with them and in that case we would have a policy rate at the short end of 3 ¼, to 3 ½%. And 10-year rates from anywhere between 3 ½, maybe its 3.8%, maybe as high as 4%. And so that means you’ve got a rising and flattening yield curve. We need to pay attention to that because in the past rising and flattening yield curves tend to proceed recessions, although not with any immediacy. Sometimes there could be as much as two to three years in between a flattening of yield curve and the onset of the next recession.

That being said, our key message for our clients is that at this point you’ve got a rising and flattening yield curve, other signs of an aging cycle. And so it makes sensed to gradually prepare for a late cycle environment. And what does that mean? Well it means equity exposures that are tied to business spending, like energy, tech and financials. It means reducing exposures to the riskiest parts of the high yield market. And for anybody that has been following the underwriting standards in high yield, they’ve been extremely lax for quite some time. It means having plenty of spare liquidity on hand to take advantage of any oversold conditions, and equity and credit markets that might pop up. And it also means looking at things like distressed debt and commercial real estate that have more frequent step up clauses to take advantage of rising inflation.

And it also means preparing for equity market volatility that’s higher than equity market returns. And that means phasing into investments more slowly and more cautiously. So that’s the story on interest rates in this week’s Eye on the Market we go through a little bit more detail about why there are often a couple of things people say about why the Fed won’t tighten and that there’s a tremendous amount of labor market slack. And if you look at the employment to population ratio, it’s still plenty of slack. We adjust for demographics to show that’s not the case. And we disprove in other theory that the Fed won’t tighten because of the adverse impact that would have on the Treasury and the cost of the federal debt. And so we conduct an exercise where we look through the actual composition of the Treasury debt re-price it rolling forward.

And we see that the big problem the Treasury faces, is huge new deficits in the next decade, rather than the financing cost on the existing debt. So I don’t think that the cost of financing the existing federal debts can prevent the Fed from tightening. We do spend a few minutes on Congressmen Ryan’s retirement in the context of the discussion on entitlement versus discretionary spending. And it does look at this point that we are heading for something of a unique environment in which entitlement spending is going to be something like five times larger than all non-defense discretionary spending by the middle of the next decade.

And non-defense discretionary spending includes things like science and energy, Superfund cleanup, renewable integration, clean coal demonstration products, healthcare, transportation, civil and military aviation, education, training, law enforcement. There’s a lot of things the government does and actually does pretty well. But all of those things are getting squeezed out by rising entitlement spending. So as an adjunct to the work that we’re doing on the Fed and the implication of higher interest rates we also take a look at these involvement entitlement spending numbers.

And to round out this week’s Eye on the Market. We’re talking about entitlement spending, we’ve talked about non-defense discretionary spending. We’ve also got to talk about military spending. And in that regard we spend just a few moments on the Syrian war. And the casualty rate in the Syrian war is extremely high. But we look at civil wars over the last hundred years. And in many of those conflicts around the world, the casualty rates were much higher. And either the US didn’t get involved at all, or only provided arms training, evacuation and similar levels of insolated support.

And there’s a very interesting chart in here that shows the history of the civil wars: the level of US involvement and then casualty rates. And so the reason we think this is an important thing to look at is that a pro intervention stance at this stage in the country’s economic cycle would put even more downward pressure on non-defense discretionary spending categories that we described earlier. And so I think it’s important to understand all of the pieces of government spending and the geo-political and financial consequences of intervening in foreign civil wars.

And then lastly we’ve got a couple of comments on oil prices. Oil prices have doubled since the early part of 2016. And this has gone against the expectations of some people that believed in an oil glut that would result from some combination of normalization of Iranian supply, decarbonization of transportation, which as you know if you’ve read our energy paper, we don’t really believe is happening right now. We’re not surprised to see oil prices having doubled. And we walked through what we wrote about two years ago in the January 1, 2016, Eye on the Market, where we talked about oil prices pushing higher in 2017 and 18 based on that fact that there was a massive decline in global capital spending related to oil. And in every cycle that we’ve ever seen, 40 to 50% declines and ENP spending eventually will get rid of even the most terrifying looking oil gluts. And that’s exactly what’s happened. We also anticipated at the time, that the Saudis would get tired of low oil prices given their own entitlement spending issues and that they would take steps to tighten supply.

So that’s mostly what’s happened since then-global ENP spending fell by 40%, in 2016. And the Saudis agreed to production cuts, demand continues to grow. The supply glut has disappeared and the world now faces a small oil deficient. And even in the US, while the shale companies have rebounded, they’re not really spending an excess of their cash flow as they were before 2016. So we’re not surprised by this rebound in oil prices and absent the global recession. We expect oil prices to remain above $60.00 a barrel for the next twelve to eighteen months.

So thank you for listening, this is a companion piece to the May, eye on the market. And I look forward to talking to you all next month.

Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy, for J.P. Morgan Asset Management, and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market, by contacting your J.P. Morgan representative. If you would like to hear more, please explore episodes on iTunes or on our website.

This podcast is intended for informational purposes only, and is a communication on behalf of J.P. Morgan Institutional Investments, Inc. a Member of FINRA and SIPC. Views may not be suitable for all investors, and are not intended as personal investment advice or as a solicitation or recommendation. Outlooks and Past Performance are never guarantees of future results. This is not investment research. Please read other important information. Please read other important information.

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