Given that the stock market generally discounts events at least 6 months in advance, summer is the time for judging the upcoming market year. Investors are turning their focus to 2020 – particularly prospects for world economies, corporate earnings and interest rates. There are four major economic factors driving market expectations right now. In order of importance:
Dovish central banks. Investors expect continued monetary “accommodation” from central banks, including 2 interest rate cuts from the U.S. Federal Reserve before year end. A sudden revival in growth could postpone cuts, but U.S. inflation remains low and below the Fed’s target. Rate cuts are coming. If they don’t, stock markets will revolt.
Rising corporate earnings. Second quarter results, which have begun to flow in recent weeks, have been decent, but not exciting. Weakness in foreign economies and slack domestic capital spending have been offset by ongoing record share buybacks. One key for the remainder of 2019 will be the trend in aggregate earnings estimates for next year. Right now, expected 2020 S&P 500 operating earnings are about $185 per share, which is a gain of about 10% over 2019.
Stabilizing global economic trends. Recent global economic data have been encouraging. Improving Chinese data remain somewhat inscrutable, but indications are that the worst may be behind us in both developed Europe and emerging market economies. U.S. employment and consumer spending have held up well.
Waffling trade war sentiment. Stocks were given a reprieve in late June after a trade “truce” between the U.S. and China emerged from the G20 summit. Negotiations have restarted in hopes of a final deal later this year. Timing is very difficult, however, as the Chinese have every incentive to “wait out” a Trump regime. Meanwhile, the President appears ready to place 25 percent tariffs on an additional $300 billion of Chinese imports at any time. This one is a push at best.
These four factors obviously interact with one another. If the global economy suddenly takes off, for example, central banks will be less likely to cut rates. These two outcomes would tend to offset one another in terms of their effect on share prices. A trade deal that reinvigorates Chinese imports and U.S. capital spending could turbocharge earnings for U.S. industrial firms. The point is that various combinations of positive and negative outcomes on these four variables will notch economic growth, profits and interest rates up or down. Predicting how they will turn and fold and react with one another is quite difficult.
There’s another important point to make about these variables, however. George Orwell said it best: All animals are equal, but some are more equal than others. He was talking about central bankers! The U.S. stock market is tracing new highs not only because, as we noted above, profit expectations for 2020 are healthy, but because central bankers everywhere have implemented some of the most aggressive monetary easing in history. How aggressive? Interest rates on dozens of European junk bonds recently went negative! Disappearing interest rates drive price/earnings multiples ever upward.
Simple math says a 17 multiple on $185 of 2020 earnings yields a fair value of 3145 for the S&P 500 by the end of next year. But simple math also says interest rates can’t go below zero – yet here we are. If central banks decide to continue to drive interest rates underground, then price/earnings multiples for stock markets everywhere will remain elevated. Perhaps central bank policies could be listed as items 1 through 100 on our 4-item list. Now that’s simple math!