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Sunday Night Insight
October 14, 2018
The Unsteady Undertow Commands the Seas (Temporarily)
Sharmin Mossavar-Rahmani
Brett Nelson
Maziar Minovi
Andrew Dubinsky
Michael Murdoch
Mary Rich
Chief Investment Officer
Head of Tactical Asset Allocation
Managing Director
Vice President
Vice President
Vice President
The 7.8% intraday peak-to-trough decline in US equities between September 21st and October 11th
has rattled investor confidence. Numerous headlines of stock market “carnage” have further eroded
their confidence. As a result, some of our clients have asked whether this drop signifies the beginning
of the end of a nearly 10-year bull market.
We do not think so. So far, this pullback is actually smaller than the two prior downdrafts we
experienced in late January and in mid-March, neither of which derailed the US economy nor the bull
market. The steady factors we highlighted in our annual Outlook—such as economic growth, benign
inflation, robust earnings, and low probability of recession—have not dissipated. Furthermore, while
the investor focus has shifted to the risks around the unsteady undertow, most of these factors are,
on balance, less concerning today than they were at the beginning of 2018.
Of course, that is not the case across all geopolitical concerns. While trade tensions with Mexico and
1
Canada have abated, those with China have certainly deteriorated and will continue to do so for the
foreseeable future. But, in aggregate, there has been more improvement than deterioration, in our
view.
In this Sunday Night Insight, we will provide a brief update on the steady factors and unsteady
undertow. We then conclude with our view that the steady factors will likely continue to win this tug-ofwar
between the two.
Steady Factors
While the headlines warn of equity market carnage, the facts do not support such alarming headlines.
The S&P 500 is still up 5.1% on a year-to-date total return basis and financial conditions remain at
easier levels today than they did when the Federal Reserve began this tightening cycle in 2015,
despite the recent decline in equities and 0.76 percentage point increase in 10-year Treasury yields
year-to-date. Most importantly, as highlighted by Federal Reserve Chairman, Jerome Powell, we are
in “extraordinary times” of steady growth and low inflation.
Economic Growth
Economic growth remains firm in the US. Both the Institute for Supply Management leading indexes
for manufacturing and non-manufacturing remain at very strong levels. Current activity indicators of
real GDP growth average about 3.5% for the third quarter and closer to 4% for the fourth quarter.
Forecasts for third quarter real GDP average 3.8% and fourth quarter forecasts are about 2.8%.
While growth is slowing from the 4.2% estimate of the second quarter, it is still forecast to be above
trend and we believe a modest slowdown is certainly preferable to continued growth at a pace that
was likely unsustainable and possibly even inflationary.
In aggregate, the economic data since the intraday peak of US equities on September 21st does not
point to any worrisome slowdown in GDP growth or the pace of employment. In fact, while the recent
134K increase in non-farm payrolls was less than expectations, revisions to earlier months offset the
modest headline miss and the unemployment rate still fell to 3.7%. Furthermore, this 134k increase
is above the estimated sustainable level of employment growth based on population growth and
changes in labor force participation, which our colleagues in Goldman Investment Research estimate
is around 96k. Importantly, a modest slowdown in the 3-month average of non-farm payrolls, which
currently stands at a very robust 190k jobs, is more likely to keep inflation in check.
Robust Earnings and Buybacks
Continued above-trend economic growth is supporting solid corporate fundamentals. While many are
quick to dismiss this strength to US tax reform, it is only half the story. Earnings before interest and
taxes (EBIT) expanded by a very healthy 12% in the first half of this year and are expected to grow by
double-digits again in the third quarter. This robust organic profit growth is also fueling sizable
corporate buybacks—a key source of equity market support. Our colleagues on the corporate
buyback desk expect the highest dollar amount for buybacks on record in 2018, with $1tn in
authorizations and $850bn in executed buybacks.
2
Total Return (%)
Even so, such robust earnings growth has begun to foster concern that we have reached a peak in
EPS growth. While we do expect the pace of growth to slow next year, a local peak in earnings
growth has not signified an imminent peak in the S&P 500 historically. In fact, about 3/4ths of market
peaks occurred more than two years after the peak in the growth rate of earnings. Moreover, stock
market returns have remained healthy during this period, with high odds of a positive outcome over
the subsequent 6-24 months (see Exhibit 1). In short, the market ultimately follows the path of
earnings and while their growth rate may be slowing, their absolute level is still rising.
1. Average / Median S&P 500 Returns Following Peaks in Earnings Growth
30%
Average Total Return Median Total Return % of Positive Returns
25%
82%
25.8%
91%
20%
67%
19.2%
15%
13.4%
12.0%
10%
5%
5.3%
3.4%
0%
Next 6 Months Next Year Next Two Years
Source: Investment Strategy Group, Bloomberg.
Inflation and Interest Rates
Inflation data has remained at relatively low levels for all of 2018, as shown in Exhibits 2 and 3. In
fact, some of the most recent data released in October have ticked slightly lower. Average hourly
earnings dropped to 2.8% from the prior month’s level of 2.9%. Headline CPI dropped to 2.3% from
2.7% and Core CPI ex-food and energy remain at a low 2.2%, unchanged from the prior month. The
Federal Reserve’s preferred inflation indicator, Core PCE, also remains low at 2.0% which is in line
with the Federal Reserve’s target, and unchanged from the prior month.
While 10-year Treasury yields have risen by 0.76% (or 76 basis points) over the course of 2018, we
do not think the resulting 3.2% yield is enough to derail US economic growth. Keep in mind that most
of the recent increase since late August was due to stronger real growth rather than runaway inflation
expectations. We expect interest rates to range between 3.0% and 3.5% in 2019 with a midpoint of
3.25%, barring any major geopolitical conflicts such as one between US and China and or escalating
conflicts in the Middle East.
3
YoY %
2. Average Hourly Earnings
5%
Average Hourly Earnings (%YoY)
Average Hourly Earnings of Production and Nonsupervisory Empoyees (%YoY)
4%
3%
2.8%
2.7%
2%
1%
0%
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Note: Average hourly earnings is available for the private sector starting in 2006 and is released
in the monthly employment report. The BLS hourly earnings data for production and nonsupervisory
employees, ~80% of the private sector, is available back to 1964.
Source: Investment Strategy Group, Haver.
3. Measures of Core Inflation: Core PCE and Core CPI
6%
Core PCE YoY
Core CPI YoY
5%
4%
3%
2%
2.2%
2.0%
1%
0%
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Source: Investment Strategy Group, Haver.
Of course, the recent backup in interest rates is providing equity investors with another source of
angst. Yet our work suggests there are several reasons why rates could continue to rise before
becoming a material headwind for stocks. First, the 4% trend growth rate of nominal US GDP—
reflecting 2% real growth and 2% inflation—remains comfortably above the 10-year Treasury yield of
4
US 10-Year Treasury Yield (%)
3.2% (i.e. the cost of borrowing). Stocks typically struggle when the cost of borrowing exceeds the
nominal growth of the economy (see Exhibit 4). Second, the recent backup in interest rates was
driven primarily by improving real growth expectations, not higher inflation. This distinction is critical,
because higher rates in response to improving real growth tend to benefit earnings sufficiently to
overcome the downward pressure they place on valuation multiples. Finally, it will take a number of
years before higher rates meaningfully impact aggregate S&P 500 interest expense, considering 91%
of S&P 500 debt is fixed-rate and only 13% matures over the next two years.
4. Inflection Point for Negative Correlation Between Stock Prices and Bond
Yields
6
5
5.1
4
3
3.2
3.9
2
1
0
Current Historica l Since 1962 Adjusted for Today's
Lowe r Equilibrium R ate*
Source: Investment Strategy Group, Bloomberg.
Yield at Which Stock Prices and
Rates Become Negatively Correlated
*Adjusts for the reduction of 1.25 percentage points in the long-run equilibrium nominal
rate, in line with the shift in Federal Reserve projections since 2012.
Low Probability of Recession
We continue to maintain a low, 10%, probability of recession driven by:
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The positive trend of leading economic indicators
Low levels of inflation
The continued slow but steady pace of Federal Reserve interest rate hikes. We believe that
Federal Reserve Chairman Powell’s recent commentary indicates that the FOMC will continue
to be driven by data and financial market conditions. Their stated goal is to extend this
expansion “indefinitely.” 1 While the Federal Reserve dots point towards four more interest rate
hikes by the end of 2019, we do not think that such hikes materially increase the odds of a
recession in an economy that continues to grow at levels that are generally regarded as above
trend growth in the US.
Recent steepening of the yield curve. We have highlighted two measures of the yield curve as
sign-posts we watch as an early harbinger of a recession. Both have steepened since their
lows, as shown in Exhibits 5 and 6.
5
Spread (%)
Spread (%)
5. US 1-10 Treasury Yield Spread – Through October 12, 2018
4
US 1-10 Treasury Yield Spread During 2018
3
1.2
2
1.0
1
0
0.51
0.8
0.6
0.4
0.51
-1
0.2
-2
0.0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct
-3
-4
1953 1960 1967 1974 1981 1988 1995 2002 2009 2016
Source: Investment Strategy Group, Bloomberg.
6. “Near-Term Forward Spread”* – Through October 12, 2018
3
2
1.2
1.0
“Near-Term Forward Spread” During 2018
1
0.78
0.8
0.6
0.78
0
0.4
0.2
-1
0.0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct
-2
1996 1999 2002 2005 2008 2011 2014 2017
*“Near-Term Forward Spread” is the implied 3-month forward yield 18-months from now.
Source: Investment Strategy Group, Bloomberg.
6
Unsteady Undertow
As market observers attempt to explain the recent drop in US equities, the risks of geopolitical factors
have garnered considerable attention. Potential US retaliation over the recent disappearance of a
Saudi journalist has only added fuel to the fire of worries given the risk that oil exports could be used
as a political weapon in a world with tighter oil supply thanks to impending US sanctions on Iran.
As we review the geopolitical developments of 2018, it is clear that some of the risks have abated
while others have increased. With the exception of a significant spike in oil prices due to the impact of
sanctions on Iran or any escalation in US-Saudi tensions, we believe that the net impact of these
shifts is not material enough to derail the US economic expansion or bull market.
Risks that have abated
Mexico: the election of the left-of-center populist president (Andrés Manuel Lopes Obrador referred
to as AMLO) has reduced fear of a reversal of recent reforms. While concerns about fiscal profligacy
and reverting to a nationalist energy policy that reduces oil production may reappear, AMLO does not
take office until the end of the year.
Brazil: The strong showing of Jair Bolsonaro, a law-and-order former army captain, in the first round
of elections and the latest data that points to a 75% probability of Bolsonaro becoming the next
president of Brazil has provided a boost to the Brazilian real. His current standing has substantially
reduced the election of another left-wing worker’s party candidate who would keep the status quo in
Brazil.
NAFTA: The agreement on a revised NAFTA deal between the US, Canada, and Mexico on
September 30th meaningfully reduced the risk of the US withdrawal from NAFTA. While the new
agreement, US-Mexico-Canada Agreement (USMCA), has not been ratified by the Mexican and
Canadian national parliaments nor by the US congress, and a divided congress after the mid-term
elections may lead to some uncertainty, we believe it is likely to be ratified.
US-EU Trade Friction: Tension between the US and European Union eased significantly after a July
2018 deal between European Commission President Juncker and President Trump to “work together
toward zero tariffs, zero non-tariff barriers and zero subsidies on non-auto industrial goods”. The
coast is not totally clear given the threat of auto tariffs, but we do not anticipate any significant
increase in trade rhetoric in the near future.
Risks that have increased
China: The trade war with China continues to escalate and as we have stated before, we believe that
it cannot be resolved simply by China importing more US goods. The issues range from:
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A large and growing trade deficit with China
Industrial policies & unfair trade practices that reduce competition, such as subsidies and
“dumping good at below-market prices”
“Made in China 2025” policies which “harm US companies”
7
Price Indexed to 12/31/2017
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Uneven tariff rates and the banning of some US goods
Intellectual property theft
Forced technology transfer
Strategic US technology acquisitions
Outright cyber theft
Foreign ownership restrictions
Recent headlines that the trade war may be escalating to a cold war are not without merit, as we
believe that US-China relations are changing on a more structural basis and will have a longer-term
impact. On a short-term basis, however, US exposure to China is limited with merchandise exports,
corporate profits and foreign claims at about 1% of GDP. As seen in Exhibit 7, the Chinese equity
markets have also deteriorated much more significantly than US markets in 2018.
Of course, specific stocks with greater exposure to China through higher sales have underperformed
the S&P 500 by about 6% since the latest tariffs were imposed on $200bn of Chinese products, as
shown in Exhibit 8.
7. Impact of 2018 US Trade Actions on Equity Markets – Through October 12, 2018
115
110
105
100
95
90
85
80
3/8: steel & aluminum
tariffs announced
1/22: solar
panels &
washing
machines
tariffed
3/22: tariffs on
$50bn of Chinese
goods announced
5/29: US confirms
tariffs on $50bn will
be implemented
5/23: investigation
into tariffs on auto
imports announced
3/23: US implements
metal tariffs on China,
which retaliates
6/18: tariffs on
additional $200bn of
Chinese goods
announced
7/6: US implements
$34bn (of $50bn)
sanctions on China,
which retaliates
9/24: US
imposes 10% tariffs
on $200bn, China
retaliates
7/31: US
considers 25% rather
than 10% tariffs on
$200bn
75
70
S&P 500 China A Shares
Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18
103.4
72.0
Source: Investment Strategy Group, Bloomberg.
8
YTD Relative Performance
8. US Stocks with High China Sales vs. S&P 500
106
104
US Stocks with High China Sales vs. S&P 500
102
100
98
96
94
92
90
88
9/24–
10/11
-6.4%
86
Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18
Note: High China sales basket is aggregated and defined by Goldman Sachs Global Investment Research.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Bloomberg.
Italy: Concerns about Italy have risen to peak levels since the election of a populist government in
May and credit default swaps have increased to reflect these higher risks. The government’s
expansive fiscal plan, with a proposed budget deficit of 2.4% of GDP, may be rejected by the
European Union commission and result in rating downgrades. While the EU is likely to manage this
situation in its usual incremental and reactive way, the possibility of new elections in late 2019
reigniting euro viability questions will keep Italy on our radar screens.
BREXIT: It is hard to know whether Brexit risks are unchanged, higher or lower given the minute by
minute headlines out of the UK. Our base case remains that while the internal politics of the
Conservative party will keep uncertainty at elevated levels and the European Union will not
compromise on its key tenants of free movement of goods, services, and people, the two sides will
agree to a deal that defers the difficult choices on the shape of a final agreement with the EU until late
2020.
The Middle East: Risks in the Middle East have not changed substantially with respect to Iraq, Syria,
or even the impositions of sanctions on Iran. However, the disappearance of the Saudi journalist who
entered the Saudi Embassy in Turkey on October 2 nd has the potential to raise risks to global oil
supply. While there has been a global uproar, it is not yet clear whether the US will impose serious
sanctions or Saudi Arabia would retaliate by reducing oil exports if the US finds sufficient evidence
regarding the alleged killing of the Saudi journalist. The recession in 1973-74 was partly due to the
quadrupling of oil prices due to the Arab Oil Embargo. Later in that decade, the Iranian Revolution
and the Iran-Iraq War also led to a 2.5 times spike in oil prices that, along with Federal Reserve
tightening by then Chairman Paul Volcker, led to a US recession. While we think it is unlikely that
Saudi Arabia would react so aggressively in the face of serious US reprisals, we note that it remains a
real risk.
9
Cumulative Mutual Fund and ETF Flows ($Bn)
Some Notable Observations
US Equities Have Been Shunned All Along
In both our 2018 Outlook and mid-year update, we highlighted the surprising absence of inflows into
US equities based on flows into mutual funds and Exchange-Traded Funds. As shown in Exhibit 9,
flows into US equities were negative in 2018, even before the recent downdraft. In fact, US equities
have seen outflows of $81 billion through August 2018 (based on the most recent comprehensive
data), while non-US developed equities and emerging market equities have had inflows of $72 billion
and $20 billion respectively. This is further evidence of our view that while sentiment and short term
positioning among speculators and hedge fund managers shifts frequently, more stable investors
have shunned US equities during this long bull market in favor of other developed and emerging
market equities and global bonds.
This steady outflow of assets from US equities has been offset by record levels of stock buybacks by
US companies given high levels of profitability and incremental cash from repatriation of overseas
earnings, as mentioned above.
9. Cumulative Mutual Fund and ETF Flows (US$bn)
2100
US Equities Non-US Developed Equities EM Equities Global Bonds
2,032
1600
1100
830
600
283
100
-400
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
-266
Note: Based on ICI weekly estimates through August 30,2018. Flows exclude reinvested dividends.
Source: Investment Strategy Group, ICI.
Some Headwinds Facing the FANGMAN Stocks Will Persist
The basket of FANGMAN (i.e. Facebook, Apple, Netflix, Google, Microsoft, Amazon and Nvidia)
stocks have dropped across the board from their respective peak price levels, with Facebook’s 29%
decline the largest and Apple’s 4% decline the smallest among the group. Even so, each of the
stocks, with the exception of Facebook, still have positive year-to-date returns and have outperformed
the S&P 500, as shown in Exhibit 10.
10
10. FANGMAN Recent Performance and Contribution to S&P 500 Earnings
and Market Cap
YTD Return
(Through 10/12)
% Decline From
2018 Peak
% of S&P 500
Earnings
% of S&P 500
Market Cap
1 Netflix 76.9% -19.0% 0.0% 0.6%
2 Amazon 52.9% -12.3% 0.2% 3.6%
3 Apple 32.8% -4.3% 4.4% 4.4%
4 Microsoft 29.7% -5.2% 2.4% 3.5%
5 Nvidia 27.6% -14.8% 0.2% 0.6%
6 Google 6.4% -12.8% 1.9% 3.2%
7 Facebook -12.9% -29.3% 1.3% 1.8%
FANGMAN 23.9% -7.1% 10.4% 17.7%
This is not a recommendation to buy or sell individual securities but rather an assertion that these
stocks represent a small portion of S&P 500 earnings. Anyone looking to buy or sell single name
equities should consult Goldman Sachs Global Investment Research.
Source: Investment Strategy Group, Bloomberg.
Nevertheless, we believe that some of the headwinds that have plagued this sector will continue.
These include:
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Data privacy issues impacting a broad range of companies, including Facebook, Google,
Twitter, Alipay and Tencent.
High likelihood of greater regulatory scrutiny in the US 2 and Europe as policy makers
increasingly believe that these companies will not address “the privacy and security issues of
social media users” 3 on their own.
Increased focus by ESG investors (Environment, Social, and Governance) that many of the
technology and social media companies are falling short on social and governance issues.
While this basket of stocks may or may not lead the market in the future, it is important to note that
they represent only 10% of S&P 500 earnings.
Investment Implications
The recent market downdraft has understandably rekindled fears that the longest bull market in
history is coming to an end. While there are no certainties in investing, we do not think the odds
support that conclusion based on our read of the steady and unsteady factors discussed above. Keep
in mind that about 75% of historical US bear markets—defined here as equity market declines of 20%
or more—have occurred during economic recessions. In fact, US equity returns have remained
favorable until about five to six months prior to the onset of recession, highlighting the penalty for
prematurely exiting the market (see Exhibit 11). With only 10% odds of recession over the next year,
we think the economic backdrop remains favorable for stocks.
11
Average 6m Price Return
% of Positive Price Returns
11. S&P 500: Returns Based on Time Until Next Recession
Median 6m Price Return
% of Positive Price Returns (rhs)
8%
100%
6%
5.8%
6.4%
90%
4%
3.7%
4.4%
4.5%
80%
70%
2%
60%
0%
50%
-2%
40%
-4%
30%
20%
-6%
-8%
-5.7%
31 to 36 25 to 30 19 to 24 13 to 18 7 to 12 1 to 6
Months Prior to Recession
10%
0%
Source: Investment Strategy Group, Bloomberg.
Of course, none of the supportive factors discussed above precludes further bouts of equity volatility.
As we highlighted at the beginning of the year, the historical probability of a 5% or greater correction
from current valuation levels was 96%. Yet these statistics alone do not justify underweighting
equities, since such pullbacks often occur after sizable equity rallies, as this year reminds us.
Moreover, such pullbacks are quite normal historically. After all, stocks have suffered a median of two
pullbacks of at least 5% and one of at least 10% per calendar year in the post-WWII period, leaving
both the frequency and magnitude of this year’s dips in line with past experience. Most importantly,
years that experienced a similar number of pullbacks as 2018 nonetheless ended with a median gain
of 6% and had 77% odds of a positive return.
Conclusion
Although we have painted a less alarmist view of recent market weakness, we are by no means
Pollyannaish. While bull markets do not die of old age, they do become more susceptible to ailments
over time. Yet as we survey the tug of war between the steady factors and the unsteady undertow,
we do not think the balance of risks is strong enough to topple the ongoing US expansion and the
continued growth of corporate earnings it supports.
That said, this viewpoint does not preclude further market volatility and the market may still make new
lows if the current downdraft persists. But history suggests the bull market is likely to continue until
about 5-6 months prior to the end of this economic expansion. Thus, it will take a significant increase
in the odds of an imminent recession to provide the trigger—that has been lacking thus far—to
tactically underweight equities. In the interim, we continue to recommend that clients maintain their
strategic allocation to US equities.
12
Sources: Investment Strategy Group, Bank for International Settlements, Bloomberg, Datastream, Goldman Sachs Global
Investment Research, Haver, International Monetary Fund, Teneo Intelligence.
Endnotes:
(1) Kate Davidson and Sarah Chaney, “Fed Chair Powell Sees ‘Remarkably Positive Set of Economic
Circumstances,’” The Wall Street Journal, October 3, 2018.
(2) Statement by the Acting Director of FTC’s Bureau of Consumer Protection Regarding Reported Concerns about
Facebook Privacy Practices, March 26, 2018.
(3) Senator Mark. R Warner, Press Release, September 28, 2018
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person.
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