One of the key points from SocGen’s year-ahead outlook for US equities is that irrespective of whether a “Phase One” trade deal and an inflection in the data manages to propel the S&P to ~3,400 in a “melt-up” move during the first half of 2020, at some point there needs to be earnings growth.
“From a price perspective, the lessons of previous mini-cycles could support a melt-up in the S&P to 3,400 [but] we believe there will be a need for earnings to grow next year”, the bank wrote, in a piece out last week. Their base case, by the way, is still for a shallow US recession next year.
The third quarter brought the first YoY decline in US corporate profits since 2016. The good news was that the drop wasn’t as pronounced as expected, but nevertheless, the blockbuster growth catalyzed by the tax cuts and buybacks is a thing of the past.
This presents a somewhat vexing problem for the bull contingent in the new year. The vast majority of the S&P’s gains in 2019 came courtesy of Fed-inspired multiple expansion.
SocGen highlighted that last week, and Goldman brings it up in their global strategy year-ahead piece, dated Monday evening. Suffice to say this is hardly just a US phenomenon.
“A significant proportion of the rise in equity markets in 2019 has come from valuation expansion given that profit growth has been generally weak; Asia and Japan have posted slightly negative earnings growth, and the US and Europe low-single-digit growth”, the bank’s Peter Oppenheimer and Sharon Bell write, adding that “for the US and Europe, valuation has accounted for nearly 80% of the return so far this year”. It’s even more pronounced in Japan and emerging markets, where earnings have declined.
Some of the “huge returns” narrative is a tall tale – that is, it’s a function of when we’re measuring from. If you look at returns from the beginning of 2018, it’s been “fat and flat”, as Goldman likes to put it. The range is shown in the following simple figure:
Recently, equities have broken out of the range amid the pro-cyclical rotation that’s accompanied positive sentiment around trade and the fading risk of a crash-out Brexit scenario (green arrow in the figure).
“Since late August, however, there has been a renewed bout of optimism reflected in equities that has propelled many markets through the top end of their previous range”, Goldman goes on to write.
That’s just a rehashing of the basic premise behind SocGen’s “fourth mini-cycle” thesis.
“We are facing two possible scenarios in 2020: 1) a mild recession, which is our central scenario, with two quarters of negative GDP growth in 2Q and 3Q, at a respective -0.7% and -0.8%, with full-year GDP growth at +0.7%; or 2) the start of a fourth mini-cycle”, the bank said last week, on the way to breaking down “the characteristics of the previous three mini-cycles”, an exercise that showed each one lasting around 3.5 years on average.
“Should there be a fourth mini-cycle, the current economic cycle would be extended to 2023-24”, the bank said.
The worry, for pessimists anyway, is that in the absence of robust profit growth and given central banks have limited room to maneuver after 2019’s epochal dovish pivot, equities may have run too far out ahead of the macro. In other words, stocks “better be right”. Here’s a visual:
Note the disconnect between the dark blue line and the light blue on the right-hand side.
“While the macro backdrop should be broadly favorable for equity markets and, in the absence of a recession, profits are likely to grow, equities already appear to be pricing in a broad economic recovery, following the rally in the past couple of months”, Goldman’s Oppenheimer goes on to say, in the course of explaining the visual.
“Exhibit 5 benchmarks year/year changes in Global P/E ratios (based on 12-month-forward consensus expectations) against our Global CAI”, he notes. “The relationship is fairly good and suggests a robust recovery in activity already”.