Early in January, Barclays’ Maneesh Deshpande joined Wells Fargo’s Chris Harvey (and others) in slashing his year-end 2019 S&P target on the heels of a truly abysmal Q4 for risk assets that featured, among other things, a blowout in credit spreads, a mini-bursting of the leveraged loan bubble and at times dramatic declines in equities.
“The reduction of 2019 S&P 500 target is driven by a combination of a drop in EPS projection and earnings multiple”, Deshpande wrote.
To say a lot has happened since then would be an understatement. Risk assets of all stripes have rallied (hard) on the back of the Fed’s “blink for the ages” and a concurrent dovish pivot by the FOMC’s global counterparts.
At the same time, the “synchronous global slowdown” story has gathered adherents, and the irony is that the worse the outlook gets, the more prone central banks will be to embark on a risk-asset-friendly reflation effort. It’s the old “bad news is good news” dynamic that has variously surfaced during fleeting bouts of panic in a post-crisis world dominated by central bank forward guidance and trillions in asset purchases.
Now, we’re at a kind of crossroads. Market participants are searching for signs of a bottoming in the data, questions are being raised about the capacity of monetary policy to ride to the rescue should things take another turn for the worse, “radical” ideas about fiscal policy are becoming more mainstream and an imminent end to the trade spat between the world’s two largest economies seemingly raises at least as many questions as it answers.
At a more granular level, the US economy is holding up relatively well compared to the rest of the world, but there’s talk of an earnings recession as analysts and market participants fret about the prospect that a trio of margin headwinds (rising wage costs, higher interest rates and tariff-related price pressures) will collide with a waning fiscal impulse to push profit growth negative for corporate America.
Read more about the earnings recession story
Indeed, consensus now expects negative earnings growth for Q1 and expectations for a “hockey stick” inflection (see red annotation below) in Q4 are all that separates us from profitability essentially flatlining in 2019.
It’s with all of that as the backdrop that the above-mentioned Maneesh Deshpande is out with a new note that finds him delivering a rather sobering assessment of the road ahead for US equities.
“In our view, U.S. equities are trading close to fair value after rebounding from the lows of December and any further upside is likely to be limited”, he writes, adding that Barclays “expects almost no earnings growth for 2019, primarily because of a slowdown in non-U.S. economies.”
You’re reminded that Deshpande’s 2019 SPX target is 2,750 or, more to the point, about where we are now.
When it comes to profits, Deshpande notes that “while earnings growth was always expected to decline in 2019 as the one time effects of fiscal stimulus abate, the expected magnitude has increased substantially over the past few months.”
Indeed, consensus expectations for 2019 earnings growth dropped from 10.5% when stocks were at the highs last September, to 7.3% by the end of last year, to just 3.5% now.
“Figure 7 calculates the decline in consensus earnings growth projections over the same calendar months for the past few years and we see that the decline is quite unusual”, Deshpande goes on to write, noting that “the closest comparable episode was during 2015 and 2016.”
What accounts for the marked deterioration in the outlook for corporate Americas’ collective bottom line?
Well, for Barclays, it’s down to “imported trouble”, where that means that “this dramatic drop in earnings expectations is being driven by a slowdown in non-US economies.” Here’s a bit of additional color on that:
While the U.S. economy continued to accelerate during 2018, non-US economic growth already peaked in the beginning of 2018. In our view the key driver for this is the reversal in the China credit cycle, which also started to turn around at the end of 2017. We emphasize that this credit growth slowdown was self-induced by the Chinese authorities as they sought to reverse the effect of their previous round of fiscal stimulus initiated in 2016. While the slow-down in non-U.S. economic growth only marginally impacts the U.S. economy since it is largely closed and dominated by personal consumption, that does not mean U.S. equities are immune. In particular, 30% of total sales for companies in the S&P 500 index are of international origin, and this percentage is even higher for some sectors.
Given the storm clouds gathering abroad, it probably comes as no surprise to you that stocks with high international revenue exposure have seen the biggest drop in 2019 consensus EPS expectations and have been the largest contributors to the aggregate decline in overall profit growth forecasts.
For Deshpande, the similarities with 2015-2016 are no coincidence. While plunging crude prices contributed to the “mini-industrial recession” that played out three years ago, that period also coincided with turmoil in China and a trough in the country’s credit cycle.
Obviously, the prospect of a “kitchen sink” stimulus effort from Beijing is one of the main catalysts bulls are hanging their hats on when it comes to a prospective (and sustained) revival of reflation trades. January’s tidal wave of credit creation sent the “right” message, and the headlines out of the NPC tip a more expansionary fiscal policy, but that’s small comfort to those who worry that the monetary transmission channel in China is impaired and that it’s not credit supply, but rather credit demand that’s the problem.
“In 2016, the Chinese authorities responded to the weakening credit conditions with significant fiscal stimulus, resulting in a rebound in US industrial production as well as 2016 earnings expectations”, Barclays’ Deshpande goes on to say, before driving home the point as follows:
The central question in our mind is whether the Chinese authorities will embark on a similar rescue operation this time around.
Again, that’s not just the “central question” for Barclays. That’s the “central question” for everyone.
As documented here on Monday evening, the bank’s Jian Chang is skeptical about the sustainability of the surge in credit growth and generally expects Beijing to persist in policy easing (both on the monetary and fiscal fronts) given expectations that headwinds to growth are unlikely to dissipate in the near term.
That said, we’ve been pounding the table for a while now on the notion that China may have bumped up against the law of diminishing returns when it comes to boosting the economy with credit creation, which means even if we do get a “V-shaped” turn in the credit cycle, it may not pack the same punch as it once did.
Here is the bottom line for US equities in light of the above (from Deshpande):
The YTD market rebound was driven by a recovery from a technical selloff in December, but further fueled by a reversal of fundamental drivers that drove the selloff in October. Although risks have become more balanced than in Q4 2018, with a potential US-China trade deal in the works, a more patient Fed, and improving efficacy of Chinese policies, we believe there is limited upside. In our view, a U.S.-China trade deal is likely to be limited in scope and a lot of its effects are already priced in. Although the China credit cycle is bottoming, a V-shaped recovery is unlikely. Further, we don’t see a significant pickup in valuations given the late stage of the business cycle.
Take that for what it’s worth when it comes to the direction of US stocks.
But do note that one thing is virtually irrefutable: the outlook for the global economy and, more narrowly, for asset prices, is becoming increasingly tethered to what happens in China.
Recall, for instance, that in the latest edition of BofAML’s European credit investor survey, some 40% of respondents said “the key to getting the Eurozone out of its current growth funk is via China stimulus supporting German exports.”
Coming quickly back to Barclays’ note, the overarching point is that while the US may be insulated, it’s not immune – that’s becoming more and more true over time as global markets become increasingly interconnected and interdependent.
Investors relearn this lesson each and every time a negative trade headline or a sour PMI print in some far-flung locale dent risk asset sentiment.
Oh well – maybe we can slap tariffs on “imported trouble”.