Recession-scale policy interventions from global central banks could revive the moribund global economy. A manufacturing pulse has recently appeared in China with an echo also appearing in the United States. Now we await confirmation signals from Europe, Japan, and the emerging markets. If the global economy gains momentum, so will corporate earnings, which haven’t grown at all in 2019. Matching recession-level central bank stimulus (good for valuations) with renewed economic growth (good for earnings) should deliver a much better yuletide season for investors this year.
Valuation and earnings combine to dictate the direction for stock prices. Every analyzable variable filters into those two categories. Shifts in sentiment impact valuations. Shifts in tax structure impact earnings. Lower interest rates impact both. Conceive of any variable and you can readily trace a path to valuation and/or earnings. Since the degree and direction of these two categories power market returns, let’s put this framework into practice to judge where we have been, where we are now and why we might be happily reliving 2012 and 2016.
Where We Have Been
Reflect upon the 4th quarter of last year. The Fed was raising interest rates and draining $50 billion a month in liquidity through quantitative tightening. That’s bad for valuations. Concurrently, President Trump raised tariff levels significantly on September 24th throwing shade on trade, manufacturing, and capital expenditures. That’s bad for earnings. The rapid drawdown in valuations and earnings expectations precipitated a rapid 20% stock market drawdown into year-end. Fortunately, as the calendar turned, so did the Fed’s rhetoric. What began as a change in tone became a change in policy as the Fed began cutting rates in July. This was good for valuations and helped drive the stock market higher. Unfortunately, corporate earnings didn’t follow suit. The global economy sputtered under de-globalization policies in the US, Britain, Hong Kong, etc., leading analysts to mark down earnings expectations quarter after quarter. The tension between rising valuations (thanks to the Fed) and falling fundamentals (thanks to restrictive fiscal policies) provided investors with a volatile and fragile marketplace. Our analysis indicated that without significant policy intervention, the decelerating economy would likely fall into recession, threatening our hard-earned gains and leading us to reduce risk exposures across our client accounts.
Where We Are
The Fed has now cut rates three times since July. But that’s small news. The big news is that after selling $750 billion of securities off of their balance sheet between September 2018 and September 2019, the Fed silently and abruptly began buying securities again. On October 11th, they formalized the process by issuing a technical statement committing them to $60 billion in monthly purchases through the second quarter of 2020. To put this in proper perspective, the Fed’s balance sheet started September at $3.75 trillion and has swelled today to $4.02 trillion. That’s a $270 billion swing in a few weeks with another $500 billion or so to come, per the statement. That’s GOOD for valuations.
Frankly, I am amazed that the Fed has committed to providing this much stimulus. Perhaps they felt they needed to keep pace with the ECB who reinstated their QE program in September, or the Bank of Japan that is locked in permanent QE. Perhaps they wanted to early vote for President Trump (wink…wink). Whatever the case, this recession-level global stimulus package only works if it translates into economic growth. If it does translate into economic growth, that’s GOOD for earnings!
This week, we received two meaningful signals that the global economy may have regained some momentum. Remember that the global economy relies on the US and China for growth. The other global economies merely draft off the big two. Over the last year, both countries have suffered significant trade, manufacturing, and capital investment drawdowns as a consequence of trade frictions. However, data released this week offered encouragement. The US October ISM manufacturing survey posted improvements in new orders, new exports, and employment which combine as positive leading indicators. Additionally, the Chinese Caixin Manufacturing survey showed material improvement in conditions, even so far as to suggest expansion afoot in China.
Reliving 2012 and 2016
IF the US and Chinese manufacturing sectors have indeed bottomed, then prospects for corporate earnings have brightened. We have seen this set up twice over the last decade. Manufacturing indices bottomed in 2012 at S&P 1,400 (thanks to BIG Fed policy) and in 2016 at S&P 2,000 (thanks to BIG Trump policy). Both inflections initiated vigorous uptrends for the market. Will this policy intervention prove enough to jumpstart global manufacturing, the global economy, and the stock market at S&P 3,000? Maybe. At a minimum, it fortifies the anticipatory gains on the year. At a maximum, it could further prolong this already historic economic cycle and bull market.
Have a great weekend,
David S. Waddell
CEO, Chief Investment Strategist