Times are good. In the near term, I expect robust year-over-year earnings growth in the United States and a bit less so in Europe, hitting or exceeding market-watchers’ expectations. Big, multinational firms based in the US are benefiting from a weaker dollar compared with year-ago levels and we’ve seen a pickup in real demand from Europe and Japan. In addition, we know that corporate tax bills are coming down. And capital spending by companies in the US, while still low, is rising. A lot of the capex spending is coming from the robust tech sector as spending on the cloud continues to accelerate.
Looking at incoming earnings data and watching global growth, I expect the equity market will respond well. However, much of the news seems to be priced in, as we observe rich, but not sky-high market valuations.
I do have some medium- and longer-term concerns:
Beyond earnings season and as we reach summer in the northern hemisphere, some forward indicators suggest caution is warranted and capital preservation will be a more important theme.
Slowing global growth: Forward indicators of industrial production, while still high, are beginning to soften on a global scale. Deceleration has been seen in Europe, Japan and China. The data are not yet alarming, though the slowdown’s rapid pace bears watching.
Squeezed margins: Close observers of profit margins will note that pipeline inflation – the prices paid for intermediate goods in the production cycle – has risen faster in China, Japan and the US than end price, or consumer prices.
This trend, if it continues, tells us that many companies have more limited pricing power than in the past. That loss of pricing power could stem from increased price transparency resulting from online shopping in the consumer marketplace and pockets of excess production capacity in some industries.
Mounting labor costs: Worse for margins is the rising cost of labor. As unemployment rates decline on the back of improved global growth, tighter labor markets allow workers to demand higher wages. Previous episodes of labor market tightness resulted in narrower profit margins and weaker returns on equity, which ultimately dampened stock market gains.
Rising rates: I believe record-low borrowing rates accounted for about 20 percent of the story behind the generation of wider margins and historical cash flow yields in the wake of the financial crisis. But today we can observe a persistent rise in borrowing costs, with the markets expecting more to come in the years ahead. This could diminish investor enthusiasm going forward.
Record debt levels: We’re in uncharted territory in terms of the amount of debt on the global balance sheet compared to the size of the world economy. The effects of rising interest rates on a highly indebted global economy remain to be seen but should be watched carefully.
In the US, higher mortgage rates and house prices have started to pinch housing affordability, a key metric for future home sales. The very important auto industry is showing signs of strain as a result of higher financing costs. Delinquency rates are rising, particularly in the subprime sector.
Specialty lenders, attracted to by the higher rates that can be charged to less creditworthy borrowers, charged into the sector when rates were at rock bottom. Many are now under stress as rates rise and borrowers have trouble paying back their loans. Similarly, delinquencies are rising among credit card and student loan borrowers.
Pinched consumers: Lastly, gasoline prices for consumers are about 18 percent higher than they were a year ago. In the past, this has tended to discourage discretionary spending. Add to the mix the rising cost of health care, which now accounts for nearly 18 percent of US gross domestic product.
In this near-term environment, I tilt toward the US over international equities given the dominance of technology and its adoption by non-tech companies in the US remains impressive. I also see better prices for the banking sector as short-term lending volumes increase while interest rates continue to rise. Additionally, health care is benefiting from better pricing power in almost all industry categories.
We are living in very prosperous times. Unemployment is very low and inflation is contained. Against that backdrop, the total return of the S&P 500 Index has averaged 17.5 percent a year since the market bottomed in March of 2009 through the end of March this year.
In my opinion, the odds are against this continuing much beyond 2018. I see sunny days stretching out ahead of us, but not indefinitely. With stock prices high and high-yield spreads tight, there is little margin for error if the financial weather starts to turn in the middle part of the year, as I suspect it might. Eventually, the rising cost of doing business and slowing economic growth will cloud today’s near-perfect conditions.
– Contact us at [email protected]