If you were looking for a little encouragement after a volatile December, the 1st quarter did not disappoint. Global markets strongly bounced back, clocking in gains that would be considered good for an entire year. Chinese Equity Markets and the Emerging Markets Index posted double digit gains. Likewise, the S&P 500 Index had its best quarter since 1998. While recoveries like this are encouraging, it’s best to temper our excitement. With the economy still humming along and corporations still making money, a quick bounce in the market is not surprising. That said, the real test for the global markets may be lurking somewhere around the corner. Global economic growth is beginning to look tenuous and US corporate profit increases are expected to decline over the next year. If the signals are accurate, we should expect more market volatility as the mood swings from worry over economic and corporate data to jubilation from an accommodating Federal Reserve.
The Fed vs. Corporate Earnings
We witnessed this mood swing during the first quarter. For the last few years, the Fed has steadily increased interest rates and planned to do so at least 3 more times in 2019. Over the same period, they reduced the size of their balance sheet. Both policies are intended to remove money from the financial system, so the economy does not overheat (think housing in 2006 and internet stocks in 1999). However, the Fed risks dampening natural economic growth if they remove too much money too quickly. In our 2018 Q4 letter, we speculated that economic data would suggest the economy was weakening and, consequently, the Fed would pause the rate increases earlier than planned to not dampen natural economic growth. In March, citing weakening economic data, that’s what they did…no more rate increases or balance sheet reductions in the foreseeable future. The market was in a glass-half-full kind of mood and rejoiced about the accommodative Fed in the face of a weakening economy.
As the year progresses, corporate earnings may sober the markets mood. Each quarter, during earnings season, corporations report their financial results. These reports include public conference calls featuring C-suite executives who explain the results and answer analyst’s questions. Slide decks are produced to provide colorful visuals on how the company performed (or perhaps distract from how the company performed). The results often have huge impacts on a company’s stock price. If a company blows past their “expected earnings,” the stock may jump in price. If they don’t hit their target, the price can tank. The entire process is a bit nonsensical. It encourages executives and investors alike to think on a short-term basis (bad idea for both) and sets up a strange expectation setting game as companies “adjust” their estimates so actual earnings will surprise to the upside.
In any case, the game is on and corporations have started to set investor expectations for lower earnings. One of the most telling warnings came from Federal Express. Given their global reach and the nature of their business (they ship stuff, but I’m guessing you knew that), FedEx’s revenues tend to be a leading indicator on the direction of the global economy. In their most recent earnings call, the CEO and CFO both expressed concerns over the global economy and reduced their earnings guidance for the remainder of 2019. FedEx is not alone in projecting lower earnings. S&P 500 companies are expecting an aggregate drop of 4% in earnings from 2018 Q1.
It would not be a surprise if reported results end up beating expectations…that is part of the game. But even if companies do beat expectations, their profit growth will likely be slowing. If that trend does play out and earnings continue to slow, one of two things will happen: either the markets will cool or valuations will become stretched as profits decrease and stock prices increase.
Now…where’s that recession everyone is talking about?
In our 2017 Q4 commentary, we considered where the US economy was in the economic cycle. We speculated that we were near the end of the expansionary period of the cycle and that signs of an economic slowdown would emerge in the first half of this year. We didn’t make a call for a recession to begin in 2020. That is beyond our predictive abilities, and everyone else’s despite their best efforts. We still believe the economy is heading that direction but there is one factor that does give us pause…. everyone sees a recession coming. It is constantly talked about in the news. Over the last few months, people who I would never expect to talk economics have brought up the upcoming recession. It is widely reported and almost universally expected. Whenever there is consensus in finance, you should always pause to consider the other side.
If there is one thing this economic and market cycle has reminded us, it is that things can continue for longer than we expect. Ten years ago, I was reading about how the Japanese economy is a bug in search of a windshield because of its massive governmental debt (210% of GDP). Since then, the Japanese have increased government debt substantially to over 250% of GDP (in comparison, the US is at 105%) and the bug is still freely flying in the breeze. Similarly, there have been countless warnings and many books written (I’ve read a few of them) about the collapse of the Chinese economy over the last 10 years. And yet it is still growing at a 6% clip per year. Everyone thought the European Union was toast in 2011 with the financial ruin of Greece; it wasn’t. Then the same was feared for the other members of the PIIGS acronym (Portugal, Ireland, Italy, Greece, Spain). Then Greece again. Then Brexit. And then Greece again. And now it’s Italy. Again. Through it all the EU continues.
With these examples in mind, a year and a half from now we might still be talking about the coming recession. We have never had an economy grow so slow for so long. This economic expansion is now the second longest in US history and, unless things deteriorate very fast, it will become the longest in just a few months. The other two economic expansions that lasted nearly this long had much higher GDP growth rates. The 120-month economic expansion in the 1990’s had GDP growth of 3.6%/year. In the next longest expansion, during the 1960’s, GDP grew at 4.9%/year. This economic expansion has seen GDP growth of just 2.3%/year. Economic busts are typically preceded by economic booms but there has been no boom. It has been a slow, mediocre rise. With such mediocrity, this economy could grind along at a slow pace for a long time.
Whether the recession is just around the corner or two years away, we expect the trend in the market to continue to be volatile. While we could return to the calm experienced in 2017, especially during the summer months, there seem to be too many conflicting themes in the markets for a lasting calm environment. There are also still unresolved major geopolitical issues – Brexit and the trade war with China, to name two – that continue to contribute to market uncertainty. Our portfolio is positioned for the peak of the economic and business cycle: a focus on strong balance sheets; avoiding low quality credit; growth positions in transformative technology or rapidly growing industries and economies that should play out in the long term, recession or not. We will continue to look for opportunities to invest capital at an acceptable level of risk.
Blake