Last week saw the Federal Reserve cut interest rates for the first time in a decade and the White House threaten to impose 10% tariffs on the remaining $300bn of Chinese imports, beginning September 1st. Investors were disappointed that trade tensions re-escalated and the Fed viewed their actions as a “mid-cycle adjustment,” but for the most part, took these developments in stride. However, threats of retaliation from China on the trade front coupled with significant depreciation of the Chinese Renminbi has cast a more ominous cloud over the outlook, with the Dow and S&P 500 both down nearly 3% and 10-year Treasury yields down 13bps to their lowest level since October 2016 to start the week.
- The market was trading on unrealistic hopes: The stock market rally that began in early-June had been built on the idea that the back half of the year would be characterized by moderate growth, lack of escalation on trade, and a very easy Fed. This is the impossible trinity of 2019 – markets want it all, but these three conditions cannot coexist. Over the past few days, high expectations met a more subdued reality on trade and monetary policy.
- Earnings don’t look great, and multiples hit a ceiling: 2020 earnings growth estimates have hovered around 11% since the end of May (we think this is too high), while 2019 earnings estimates have deteriorated; meanwhile, the S&P 500 forward P/E ratio expanded from 15.7x to a peak of 17.1x. With investor sentiment being the key driver of market performance over the last two months, rather than changes in the outlook for earnings, the stock market was always subject to a re-rating when expectations met a speed bump.
- Recession risk is contained, for now: Tariffs impact business confidence, which up until this point, has weighed on investment spending and the manufacturing sector. The risk, however, is that weakness in manufacturing begins to infect the labor market as companies try and maintain profits by slashing employment. For an economy like the U.S. – which is 70% consumption – this is the downside scenario. Our expectation is that the U.S. and global economy bend rather than break, but recent developments further emphasize that risks are tilted to the downside.
While we are disappointed that trade negotiations have deteriorated and that the outlook for growth is less certain, we are not necessarily surprised. The growing role of politics as a key driver of the macroeconomic outlook has made forecasting far more challenging, forcing us to entertain a range of outcomes as we think about the direction of travel for the global economy. As we laid out in a recent bulletin – Lots of talk about tariffs – we see three potential outcomes; unfortunately, none of them are characterized by a lack of policy uncertainty, suggesting that elevated levels of volatility will be with us for the foreseeable future. As such, investors should ensure they have adjusted the dials down on risk in portfolios, including a more neutral allocation between stocks and bonds, a focus on income over capital appreciation, and adding some duration.
U.S. equity multiples hit a ceiling in late July
S&P 500 Index: Forward P/E ratio
Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Price to earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since August 1994, and FactSet for August 5, 2019. Average P/E and standard deviations are calculated using 25 years of IBES history. Data are as of August 5, 2019.