The recent S&P 500 plunge had a profound effect on investors’ minds all across the globe. By the end of 2017, there was an aggressive debate on whether 2018 will be an extrapolation of abnormally consistent returns and hence low volatility or whether it will it be a wild ride with ill-controlled volatility. The recent plunge was a strong argument in favour of sceptics. However, a recent S&P 500 upward correction has bolstered the view of optimists that the drop was nothing more serious than a noise. Now it is worth analysing the fundamental factors that might move the US market, the S&P 500 in particular, in the middle run.
In accordance with the World Bank’s January 2018 forecast, the world economy will grow by 3.1% by the end of 2018. The growth will be mainly driven by a spike in investments and transnational trade. The favourable monetary policies that were in place for a prolonged period across world Central Banks will boost world GDP growth. The dynamics of world GDP growth might become the best since 2011. In fact, the World Bank has revised its June 2017 forecast (+2.9%) to +3.1% in January 2018. The chart below shows the World Bank 2018 GDP growth forecast released in June 2017 versus the forecast released in January 2018.
The World Bank provides quite a positive outlook, however, one should bear in mind that a monetary contraction can put a downward pressure on GDP growth. In fact, the rising interest rates will affect the developing economies with a high debt burden the most.
The GOP tax reform is the most vivid example of US economy stimulation measures. The corporate tax was substantially cut from 35% down to 21%. Corporates also obtained a one-time opportunity to bring back cash held abroad at the concessionary tax rate of 15.5%. Several corporations, including Apple and Cisco Systems, have already announced their plans to use this opportunity to bring cash onshore and use the funds to accelerate investments and buyback procedures.The infrastructure overhaul will cost the US government $200bn over the 10-year span. Due to the multiplier effect, the economy expects to see an additional $1.5 trillion in investments.
FactSet foresees a 16.9% increase in S&P 500 EPS growth for Q1 2018, with 18.5% growth being forecasted over 2018. Estimates of EPS growth in 2018 have already been revised in an upward direction, at 7% growth from $147 to $157. FactSet outlines this as the biggest one-time increase in EPS estimates since 1996.
The optimism is spurred by a record number of S&P 500 companies issuing positive guidance. Guidance is the company’s projection of EPS before the actual EPS results. Positive guidance is guidance that provides an estimate which is higher than the consensus estimate the day before the guidance release; hence negative guidance is the opposite. The number of S&P 500 companies issuing positive guidance in early 2018 constitutes to 127, and this is more than two times higher than the 10-year average (49 firms). Primary drivers of companies’ optimism are the GOP tax reforms, the improving global economy and the weaker dollar.
It is also compelling to understand the breakdown among industries that have issued positive guidance in early 2018 versus the 10-year average. It is obvious now that healthcare, industrials, IT and consumer staples are feeling exceptionally comfortable.
Key Rate Expectations
Ironically, the recent sell-off that occurred in the markets all over the world might have positive effects on equities in the middle run. The sell-off might force the Federal Reserve to switch from contractionary policy into a softer mode. This happened in 2010 after the S&P 500’s 17% drop; the Federal Reserve launched its urgent “Quantitative Easing 2”. In 2011 when the S&P 500 was falling 21%, the “Operational Twist” was implemented. Should we expect the Federal Reserve’s urgent actions this time?
A Weak Dollar
Due to Trump’s infusions into the economy, the budget deficit will be growing, and by 2028 it will hit $29.9 trillion. Trump’s protectionist measures can knock the US dollar further below. Currently, we observe the dollar to be at the 2014 level, and it lost 14% since its peak in early 2017.
A weak dollar is able to affect earnings of US corporations with significant operations offshore positively. Around 30% of S&P 500 earnings are generated outside of US.
The yields on long-term US treasuries are rising due to monetary contraction and rising inflation. There is a fundamental rule: the higher US Treasury yields, the lower the return on stocks. Exceptional risks exist for dividend-paying stocks, as the higher the government bonds’ returns are, the less interested investors are in pursuing returns through dividends.
It is alarming to see that the S&P 500 dividend yield (1.8%) is now very close to the 2-year Treasuries Bills yield. This means that dividend-paying stocks require a correction downward in order to effectively raise their yields to compete with the Treasuries. Industries such as telecoms, energy, REIT, which constitute of traditionally dividend-paying stocks, will have the biggest exposure to rising Treasuries yields.
Discussed above, treasury yields have a direct correlation with the key rate. The Federal Reserve has already entered the tightening cycle, and with the new chairman, Jerome Powell, the tightening policy might become even more aggressive. It is worth mentioning that the real key rate (nominal rate adjusted for CPI inflation) is still negative: -0.4%. In fact, the negative real key rate is more stimulative to the markets compared to the median key rate, which is 1.4%. However, the aggressive tightening outlook should be an alarming sign to equity investors.
The Rise in Inflation
The recent months’ oil price growth, increase in salaries and substantial infrastructure investment plans have already put upward pressure on inflation forecasts, which in turn can lead to further monetary contraction policies. The January CPI year-over-year growth was 0.2% above consensus, which verifies the negative outlook. In fact, the forward inflation expectation rate is at 3-year maximum.
To construct a reliable forecast on the industry-level, one has to consider industry-specific factors and weight factors outlined above respectively to their effect on the chosen industry.
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