Reconciling the myriad tailwinds supporting U.S. stocks near record highs and the laundry list of potential hurdles that have the potential to catalyze equity weakness on the way to making a decisive directional call is virtually impossible in the current environment due to the sheer number of embedded contingencies in the narrative.
I’ve talked a ton about this over the past couple of weeks, with the most poignant piece perhaps being the deliberately comical “Pepe Silvia”.
What makes the situation even more vexing than it already would be is the fact that the very same policies which are responsible for the euphoria in U.S. stocks are also at the heart of international risk sentiment malaise. Late-cycle fiscal stimulus stateside is bullish for U.S. equities as it underwrites record corporate profits, catalyzes buybacks, and supercharges the domestic economy, but it’s a severe drag on emerging markets to the extent it forces the Fed to lean more hawkish than they otherwise might, driving the policy divergence between the U.S. and the rest of the world wider and underpinning dollar strength.
(Bloomberg dollar index)
U.S. trade policy also serves to perpetuate the performance divergence by denting the prospects for global growth and causing palpable angst for developing economy policymakers which in turn further incentivizes investors to seek out the relative safety of U.S. assets.
Midway through last month, the dollar took a breather, helping to buoy EM sentiment, which paradoxically helped lift U.S. stocks to new records. Generally speaking, the consensus narrative now revolves around the notion that the historic divergence between U.S. stocks and the rest of the world needs to resolve itself in order to avoid spillover from EM turmoil to Wall Street, and to the extent a weaker dollar helps that resolution manifest itself in EM assets outperforming U.S. stocks in the back half of the year, that’s actually a good thing if it means an outright EM crash doesn’t finally boomerang back to the previously bulletproof S&P.
Last week, a new wrinkle emerged, as tech regulatory risk reared its ugly head and that, combined with further weakness in EM equities (off by more than 3% on the week) and FX (down for a fifth week in six), led the S&P to post its worst week since June and its first losing week in four.
FANG suffered its worst weekly drop in six months.
And then there’s the risk associated with the U.S. midterms and the special counsel probe. All it’s going to take to send ES and USDJPY tumbling is a Mueller tape bomb out of nowhere.
Finally, ongoing trade frictions and the threat of at least one imminent escalation with China cloud the outlook further.
It’s against this backdrop that analysts are attempting to balance the good with the bad on the way to coming to some kind of consensus about where the S&P will end up when we close the book in December on what’s been a truly interesting year.
For their part, Deutsche Bank was out recently advising caution in September for five reasons, while UBS (just to pick another example of the hat), suggested this week that while the S&P could fall 5% in the event the tariff rate in the next round of duties on China is 25% (as opposed to 10%), there are at least five good reasons to remain constructive.
Well, Goldman is going to go ahead and throw their opinion into the mix. “A number of tailwinds and headwinds exist that will determine the path of the US equity market during the coming months”, the bank writes, in a note dated Friday evening, adding that for their part, they see “these forces as roughly balanced.”
Here’s the good news, truncated and otherwise abridged for brevity:
1. 2018 continues to produce stellar economic data. Surveys such as the ISM Manufacturing Index (61.3) and NFIB Small Business Optimism (107.9) remain near all-time highs. Labor reports continue to be positive, with non-farm payrolls gaining 201K jobs and the unemployment rate holding at 3.9%.
2. Data have been positive at the micro level as analysts continue to raise profit forecasts for S&P 500 companies.
3. The savings rate was revised to nearly double its previous reading (6.8% vs. 3.2%). Last month, the Bureau of Economic Analysis revised the household savings rate upward for 10 of the previous 11 years. These additional savings are positive for equities because consumers will use the cash to either (a) spend, (b) deleverage, or (c) invest.
4. Fund positioning remains light, which suggests upside potential for investors in the near term.
5. Buybacks continue to be strong this year, but many firms will soon enter their buyback blackout period ahead of 3Q reporting season. The GS Buyback Desk reports a 50% increase in buyback executions YTD, boosted by tax reform, and expects new authorizations will exceed $1 trillion in 2018.
So that’s the good news and all of those points are just as familiar to anyone who’s been following along as the list of bad news will be. Here are the possible headwinds, again from Goldman and again truncated and abridged:
Tariffs and trade conflict represent potential headwinds to S&P 500 earnings. We previously highlighted that a 25% tariff imposed on all US imports from China could slash our 2019 EPS estimate by 7% to $159 and eliminate any earnings growth for the S&P 500 next year.
We expect continued monetary policy tightening will weigh on stock valuations. Departing from the pattern during previous hiking cycles, S&P 500 forward P/E is flat since the Fed began its current hiking cycle nearly three years ago in December 2015.
Foreign markets have also come into focus. Since 2003, when the MSCI EM index has dropped by more than 5% the S&P 500 typically falls about half as much.
What to make of it all? Well, who knows.
Goldman isn’t really sure either as evidenced by their call for U.S. stocks to “trade sideways”, at least until the midterms. Their year-end target remains unchanged at 2,850, which is essentially another “sideways” call. For what it’s worth, the bank’s 2019 year-end forecast is 3,000.
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