Can this cycle continue, or will interest rates drag on future growth?
First quarter earnings season is winding down, yet despite US earnings growth of more than 20 per cent, stock market levels are little changed since the start of 2018. This begs the question: why doesn’t it “feel” better?
The primary reason for the muted equity price reaction to record-breaking bottom-line profits is that consensus earnings growth of around 18 per cent this year is a “known” and a relative certainty. And the more known and certain something is, the more likely it is that it is already priced into the market.
We [JP Morgan] remain confident in our forecast of 20 to 24 per cent growth in S&P earnings this year. The fact that we see upside risk to current street estimates, combined with reduced investor complacency, gives us confidence that equity markets can move higher in the second half.
We are, however, also mindful that the current anxiety in the market is less about the current calendar year and more about the longevity of the cycle. The market is in the process of trying to predict which year this expansion will end – and how. The most common known unknowns are whether first quarter earnings will be the high watermark for the year, the extent to which rising interest rates may drag on future growth, and whether there are excesses in the economy that could result in imminent recession.
So, as the market grapples less with the magnitude of earnings, and instead with the duration of earnings growth, there has emerged a healthy debate about how much to pay for an earnings stream that may decelerate, or be shorter than anticipated.
We have long believed in the exceptionally long nature of this expansion, since we argued growth would not run above trend by enough to create the traditional imbalances that tend to end equity bull markets. Now, in its ninth year, we have entered a much more traditional stage. With robust growth in the United States, and around the world, mild inflation pressure is building and other major central banks are likely to continue to join the Federal Reserve in removing monetary accommodation in the year ahead.
How might this affect financial assets? Firstly, raising rates negatively effect the value of equities. A stock’s worth can be computed as the present value of the cash flow stream that it will produce in the future. The discount rate used to calculate today’s fair value is linked to interest rates, in other words the opportunity cost of an investment, and the present value of equities tend to fall as rates rise. That’s why investors are worried about the equity multiple (generally it should be lower when rates are higher).
Secondly, and most critically, one must consider whether rising rates will ultimately end the cycle by stifling economic growth, creating the next recession. This heavily affects both the magnitude and duration of projected cash flows.
There is room for rates to continue to rise before they constrict growth. Therefore, with equity valuations having declined so far this year, we believe that as stronger earnings come through in 2018, stocks can move higher because the market is now pricing in a reasonable degree of scepticism about the health of those corporate cash flows.
By the beginning of 2019, the market will continue to look to the length of the cycle, which, of course, is harder to assess. Our base case is that the US will continue to grow at 1.5 to 2 per cent GDP for the next few years, and that rising shortterm rates will keep inflation (and longer-term rates) at bay, and perpetuate a longer, but slower, growth trajectory.
Importantly, this US stability will provide the backdrop for stronger growth outside it. Increasingly, the younger business cycles that exist globally will carry the weight of global GDP growth, and our view of moderating US growth is complemented by one of faster growth outside the country. And, of course, the world should be growing in concert.