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The stock market continues to set new record highs. The reasons are the tax bill passed by Congress; relatively low interest rates; low inflation; the perception of an improving economy; raises and bonuses being paid by some companies to their employees; and analyst predictions of higher earnings looking forward.
Hoisington Investment Management Company
The following are excerpts from the Hoisington Investment Management Company “Quarterly Review and Outlook Fourth Quarter 2017”:
Optimism is pervasive regarding U.S. economic growth in 2018. Based on the solid 3%+ growth rate during the last three quarters of 2017, this optimism is well-founded. The acknowledgement of this economic health by the Federal Reserve (Fed) is evident: they have outlined a continued pattern of increasing the federal funds rate over the coming year. Further, the solid 2017 performance of the European Union and of Japan is forecast to continue in 2018. Finally, the recent enactment of a tax cut is expected to boost U.S. economic growth in the new year. Well-regarded economic research suggests a 2.5% – 3.5% real growth rate in 2018 with continuing stable inflation. In addition, most surveys suggest a modest interest rate increase across the entire maturity spectrum of the yield curve.
Our view of the economic environment is somewhat divergent from the consensus opinion. Our analysis of concurrent and leading economic variables, including consumers, taxes, monetary policy and the yield curve, suggest that disappointing growth, lower inflation and ultimately lower long-term interest rates will hallmark the new year.
Consumer spending, the economic heavy lifter of U.S. economic growth, has expanded by 2.7% over the past year (as measured by real personal consumption expenditures, or PCE, as of November 2017). This is similar to the past eight years of the expansion, with real PCE averaging 2.5%. What is interesting about the increase in spending is that incomes have failed to keep pace. Real disposable personal income rose by only 1.9% over the past year. It was only the ability to borrow that supported the spending increase. In economic terms, borrowing is a form of dissaving. The saving rate for consumers dropped from 3.7% a year ago to 2.9% in November, a 10-year low.
Borrowing should slow in 2018. The 125 basis point increase in the federal funds rate since December 2015, and its magnified effect on short-term financing rates, coupled with deteriorating loan quality, should continue to reinforce the slow-down in borrowing at the consumer level. Therefore, both the supply and demand for credit is waning. Slower borrowing and modest income expansion, along with a potential reversal in the near historic low saving rate, means consumer spending will likely be one area of economic disappointment in 2018.
A debt-financed tax cut will provide no net aggregate benefit to the macro-economy. If the tax cuts were instead to be financed by a reduction in expenditures (revenue-neutral), then the economic growth rate would benefit to a minor degree.
Federal debt, however, still remains a problem since gross government debt recently exceeded 106% of GDP. A debt level above 90% has been shown to diminish an economy’s trend rate of growth by one-third or more. When President Reagan cut taxes in 1981 growth ensued, but the government debt was only 31% of GDP, an economic millennium from our present 106%. Looking forward, the Joint Committee on Taxation expects a $451 billion revenue gain from improved growth over the next ten years, yet it still expects the recent tax bill to add $1.1 trillion to the deficit. The Congressional Budget Office expects a $1.5 trillion increase in the deficit over the same period. According to some private forecasters, due to the front-loading of some provisions, for the next two years the federal deficit will be rising – moving from roughly 3.6% of GDP in fiscal 2017 to 3.7% of GDP in fiscal 2018 to 5% of GDP in 2019. Thus, the continuing debt buildup will have the unintended consequence of slowing economic growth in 2018 and beyond, despite the favorable multiplier contribution that individual tax cuts impart.
Although the economy may slow due to a poor consumer spending outlook and increases in debt, the real roadblock for economic acceleration in 2018 is past, present and possibly future monetary policy actions. The Fed first began raising the federal funds rate in December 2015. A year later the Fed implemented another 25 basis point increase. Three more rate hikes occurred in 2017. To raise interest rates the Fed takes actions that reduce the liquidity of the banking system. This action has historically caused a reduction in the supply of credit through tighter bank lending standards. The demand for credit is also diminished as some borrowers are priced out of the market or can no longer meet the higher quality standards. The brunt of these past and current policy moves will be felt in 2018.
In the fourth quarter of 2017 the Fed planned to reduce its balance sheet by $30 billion, an action we term “quantitative tightening” (QT). This action has and will continue to put additional downward pressure on money growth; a $60 billion reduction is expected in the first quarter of 2018, a $90 billion reduction is expected in the second quarter of 2018, and an additional $270 billion in reductions are expected following the second quarter of 2018. It is important to note that historical comparisons and analysis are unavailable as the magnitude of this balance sheet reduction is unprecedented.
Restrictive monetary policy impacts the economy through several observable phases, all of which take time to work. Initially, the monetary shift causes the federal funds rate to rise. As mentioned earlier, as the federal funds rate moves higher, the growth rates of the monetary and credit aggregates slow. A sign that this restrictive process is beginning to more meaningfully impact monetary conditions is that the yield curve begins to flatten, with short-term rates rising relative to long-term rates. Historically, as the yield curve flattens, the profitability of the banks and all similarly structured entities is diminished from this influence.
The full spectrum of monetary policy is aligned against stronger growth in 2018. A higher federal funds rate, the continuation of QT, low velocity and abruptly slowing money growth all put downward pressure on growth. The flatter yield curve will further tighten monetary conditions. This monetary environment coupled with a heavily indebted economy, a low-saving consumer and well-known existing conditions of poor demographics suggest 2018 will bring economic disappointments. Inflation will subside along with growth causing lower long-term Treasury yields.
The following information is from the FACTSET “Earnings Insight January 25, 2018”:
- Earnings Scorecard: For Q4 2017 (with 24% of the companies in the S&P 500 reporting actual results for the quarter), 76% of S&P 500 companies have reported positive EPS surprises and 81% have reported positive sales surprises.
- Earnings Growth: For Q4 2017, the blended earnings growth rate for the S&P 500 is 12.0%. All eleven sectors are reporting earnings growth for the quarter, led by the Energy sector.
- Earnings Revisions: On December 31, the estimated earnings growth rate for Q4 2017 was 0%. Eight sectors have higher growth rates today (compared to December 31) due to upward revisions to estimates and positive earnings surprises.
- Valuation: The forward 12-month P/E ratio for the S&P 500 is 4. This P/E ratio is above the 5-year average (15.9) and above the 10-year average (14.2).
Record-High Percentage of S&P 500 Companies Beating Sales Estimates For Q4 To Date
As of today (January 25, 2018), 24% of the companies in the S&P 500 have reported actual earnings and sales numbers for the fourth quarter. Of these companies, 81% have reported sales above estimates and 19% have reported sales below estimates.
If 81% is the final percentage for the quarter, it will mark the highest percentage of companies reporting sales above estimates for a quarter since FactSet began tracking the data in Q3 2008. The current record for the highest percentage for a quarter is 72%, set in Q2 2011.
It is interesting to note that companies are beating an even higher bar for estimates now relative to expectations at the start of the quarter, as revenue estimates in aggregate actually increased during the fourth quarter. On September 30, the estimated revenue growth rate for Q4 was 5.7%. By December 31, it was 6.7%. Because of the number and magnitude of these upside surprises (and continued upward revisions to revenue estimates after the end of the quarter), the blended revenue growth rate for the quarter has increased to 7.0% today.
Double-Digit Earnings Growth Expected to Continue in 2018
For the fourth quarter, companies are reporting earnings growth of 12.0% and revenue growth of 7.0%. Analysts currently expect earnings to grow at double-digit levels in 2018. However, they are also projecting lower year-over-year revenue growth in the second half of 2018.
For Q1 2018, analysts are projecting earnings growth of 16.0% and revenue growth of 7.1%.
For Q2 2018, analysts are projecting earnings growth of 16.0% and revenue growth of 7.2%.
For Q3 2018, analysts are projecting earnings growth of 17.3% and revenue growth of 5.9%.
For Q4 2018, analysts are projecting earnings growth of 28.2% and revenue growth of 4.6%.
For all of 2018, analysts are projecting earnings growth of 16.3% and revenue growth of 6.0%.
Valuation: Forward P/E Ratio is 18.4, above the 10-Year Average (14.2)
The forward 12-month P/E ratio is 18.4. This P/E ratio is above the 5-year average of 15.9 and above the 10-year average of 14.2. It is also above the forward 12-month P/E ratio of 18.2 recorded at the start of the first quarter (December 31). Since the start of the first quarter, the price of the index has increased by 6.1%, while the forward 12-month EPS estimate has increased by 4.8%.
The fundamentals of the stock market are strong at the present time. Some argue that the market is overvalued based on various ratios. Others agree but say that because of the new tax law and an improving economy, higher earnings will correct the overvaluation. Since the stock market has gone up so much so fast, there is risk of a correction, which could present a buying opportunity unless the fundamentals change.
The consensus is that the economy is getting stronger not only in the U.S. but also globally. Many expect a growth rate of 3%+ in 2018 and stable inflation. They think that the yield curve will rise not only on the short end due to the Fed raising rates, but also on the long end due to the Fed’s “quantitative tightening” by reducing its balance sheet. Hoisington disagrees.
In conditions like these, the prudent path would be to maintain a balanced portfolio of stocks, bonds and alternative investments for those whom it is appropriate. The bull stock market will end at some point. We do not know when.
Chairman & CEO
Director of Consulting
Released: January 31st, 2018 09:15 AM