February 2018

BBT-Perspectives-Market-Monthly-February-2018-Feature

The term “new normal” was coined during the rubble of the 2008-2009 great financial crisis to imply that normal business cycles were a thing of the past. Today, the business cycle is back in full force and “new normal” is a thing of the past. The recent correction in stock prices does not signal weakening economic conditions, but it does signify a healthy and normally functioning economy with asset prices performing on their own merits. In this edition of Market Monthly we credit the return of the normal healthy business cycle as the catalyst behind financial asset prices and their volatility. “New normal” is old news.

Summary:

Economic Update: The recent stock market correction was steep and swift but is unlikely to have a meaningful impact on the powerful U.S. economic engine. Fiscal stimulus is expected to add up to .7 percent to 2018 GDP growth. Fears of rampant inflation are overblown, but recent firm readings at a time of full employment should keep the Fed on path for three to four hikes in 2018 to avoid getting behind the curve.

Equity Update: Markets have hit the reset button after correcting over 10 percent in one of the most telegraphed corrections on record. Further market tremors are not out of the question in the near term. Earnings expectations for 2018 have surged higher since the end of 2017 raising the possibility earnings growth for 2018 will exceed market returns. Stock prices do not always follow earnings growth when valuations are high, so continued economic expansion remains the key behind future earnings growth.

Bond Update: 10-year Treasury yields have risen almost .5 percent since the beginning of the year, establishing a new trading range of 2.7 – 3.0 percent. Treasury issuance will surge as a result of increased government spending but municipal issuance remains tight. Now that bond markets have repriced to meet the Fed’s projected rate path, odds have increased that 10-year Treasury yields reach 3.25 percent by year-end.

Economic Update:

Positive Fiscal Impulse: The combined impulse of tax cuts and increased government spending are expected to boost GDP growth by .7 percent beginning in Q2. This double dose of government stimulus is happening while the economy is already operating near full capacity and unemployment is at cycle lows. This underscores the likelihood of modestly increasing inflation. However, the fiscal impulse is expected to have a 2-year shelf life and begin to wane as the business cycle matures into 2019.

A primary anti-inflation impulse is also a by-product of tax reform. Corporate tax cuts have come when profit margins are at all-time highs. This means firms in highly competitive industries who benefit from lower corporate tax rates may keep prices flat or in some cases, like Walmart, actually cut prices. Firms with pricing power will expand their competitive advantage and customers will win at the cash register.

At the end of the day, the case for higher inflation has gained traction, but it should remain contained and not spiral out of control.

Upcoming Fed Meeting:  Jay Powell delivers his first semiannual monetary policy testimony on Feb. 28th almost a month before the March 21st FOMC meeting. Markets are historically volatile early in the first term of a new Fed chairperson, so they will listen closely to his comments for signs of change. There are four key reasons the Fed will remain on course for a rate hike at its March 20-21st meeting:

  1. Economic Growth: The economy continues to generate positive data and the OECD index of Leading Economic Indicators is signaling continuing growth in the months ahead.
  2. Consensus: Recent speeches by many Fed governors reflect a steadfast resolve to stick to their plan of three rate hikes and have expressed almost a sense of relief that corrections have now reasserted themselves.
  3. Orderly Correction: The correction was steep, swift and orderly having regained much of its recent drawdown even though volatility remains elevated.
  4. Fiscal Impulse: Ongoing pro-growth fiscal policy should continue to give the Fed the “all clear” sign that interest rates need to normalize while the business cycle reasserts its strength.

Bottom Line: The tandem fiscal impulse of lower taxes and higher government spending should nudge the economy closer to the 3-percent GDP growth range in 2018. The Fed will continue to normalize interest rates so they are better prepared and equipped to act at signs of the next slowdown.

Equity Update:

The Correction: In our January 2018 Outlook edition we said once 10-year Treasury yields surpass 2.75 percent we expected to see rising rates begin to impact stock prices and compress PE ratios. We also indicated with a strong economy, any correction would be shallow and short. We didn’t expect to see it happen so quickly, but now that it has, records have fallen and the table has been reset. To differentiate between a correction (-10 percent) and a bear markets (-20 percent) consider the following since 1946:

Correction/Bear Occurrences Average Loss Duration Recovery # Recessions
Correction 25 -14 percent 4 months 4 months 5 (20 percent of Corrections)
Bear 11 -34 percent 15 months 26 months 7 (64 percent of Bears)

The recent market action was an overdue correction, and we expect to see 3 percent-5 percent drawdowns with increasing frequency at this late stage of a 9-year bull market. However, until and unless economic indicators begin to flash signs of recession, the risks of a bear market are low.

A final point of reference regarding corrections can be seen in the chart below, which shows the average S&P 500 drawdown (-18 percent) and recovery (+36 percent from the lows) for every midterm election year since 1962. Past patterns cannot be used to make predictions, but they are relevant in terms of the direction of the pattern. The deepest corrective phases in midterm years occur in the first half of the year with the largest rebound occurring during the fourth quarter.

BBT-Perspectives-Market-Monthly-February-2018-Policy-mistakes

Current Earnings Season: The Q4 2017 earnings season has surpassed all expectations so far. Consider the following:

  • All 11 sectors are reporting both earnings and revenue growth for Q4
  • 78 percent of companies are beating sales estimates (record high)
  • 75 percent of companies are beating earnings estimates
  • 127 companies have issued positive earnings guidance (record high)
  • 58 percent of firms are beating both earnings and sales estimates (record high)

Furthermore, expectations have risen substantially since Dec. 31st, 2017. Consider the chart below:

BBT-Perspectives-Market-Monthly-February-2018-SP-500-Growth

  • Q4 earnings estimates have grown from 11 percent to 15.2 percent
  • Q4 revenue estimates have grown from 6.7 percent to 7.9 percent
  • 2018 earnings estimates have grown from 12.1 percent to 17.9 percent
  • 2018 revenue estimates have grown from 5.7 percent to 6.6 percent

The trend shown above is the primary argument behind the quick and ongoing recovery from the recent correction. We expect the pace of earnings growth to slow later in 2018 and into 2019 but for now, business is good.

Stock Prices and Earnings Growth: Since 2014, the majority of gains for the S&P 500 have come from PE expansion due to the slow steady pace of Fed tightening with 0 percent as its starting line. At the current pace of earnings growth, the story for 2018 will be of PE contraction as earnings are poised to grow faster than share prices. As a result, valuations may remain elevated but not unreasonable.

History suggests that markets should not blindly extrapolate lofty earnings expectations into lofty return expectations. For example, consider the following observations from 90 years of market history as compiled by Standard & Poor’s where markets were up 61 times and down 29 times.

Market Direction
Last 90 years
Occurrences Negative EPS
Occurrences
Positive EPS
Occurrences
Double digit
EPS growth
Up 61 20 times (33 percent) 41 times
(67 percent)
29 times
(47 percent)
Down 29 9 times
(31 percent)
20 times
(69 percent)
14 times
(48 percent)

 

  • Earnings growth is positive 67 percent of the time and negative 33 percent of the time.
  • In down years, the S&P 500 experienced double-digit earnings growth 48 percent of the time.
  • In down years, the S&P 500 experienced positive earnings growth almost 70 percent of the time.

Current economic data suggests continued earnings growth for the next few years, but high earnings growth cannot promise high stock returns. Earnings are critical to stock prices, but sentiment and economic growth expectations are equally important in the late stages of a bull market.

Bottom Line: The recent correction was long overdue and driven by sentiment with concerns about rising interest rates. Additional tests and volatility are expected, which is normal. Earnings growth continues to accelerate and support stock prices as does a surging wave of share buybacks. Continued normalization of interest rates by the Fed will contribute to the renormalization of stock prices in the process as the recent correction reminds us all. The initial thrust to earnings from corporate taxcuts will begin to fade later in 2018 into 2019. Stay invested as stocks, despite their volatility, are expected to outpace bonds in 2018.

Bond Update:    

Bond markets are especially impacted by the renormalization theme. Treasury issuance is expected to surge with the recent government spending package with maturities focused in the short end of the yield curve. Focus is shifting to the 2-year Treasury note as a clearer signpost for market expectations of future Fed actions. Rising inflation, as we’ve discussed, is high on the Fed’s radar of things to watch as the year unfolds. A March rate hike is baked in with increasing talk of four rate hikes for 2018.

Municipal issuance remains tight as suspected with the change in tax status for pre-refunded bonds, which have historically accounted for almost a quarter of all new issuance. This strong demand with a diminished supply has been a source of stability for muni bond buyers even during the recent correction.

High-yield bond spreads spiked during the correction but have now settled down a bit. Issuers in the lower credit grade regions of the high-yield universe will signal any early signs of deterioration and widening credit spreads. Time will tell if interest deductibility limitations in the new tax bill will lead to rising defaults for marginal issuers later in the business cycle.

Yields have quickly repriced toward where many thought 2018 would finish with 10-year Treasury yields now over 2.9 percent. With accelerating economic growth and tailwinds from fiscal pro-growth policy, rates could very well be on a path toward 3.25 percent by year-end.

 

Final Thoughts:

  • The business cycle is alive and well
  • “New normal” is becoming old news as the Fed unwinds its extraordinary policy
  • Existing economic growth with an incremental fiscal impulse should nudge inflation and interest rates modestly higher but with restraint
  • The Fed remains on path for quarterly rate hikes in 2018
  • Record Q4 earnings with increasing forward expectations should continue to support stocks
  • Price earnings valuations should contract as earnings growth exceeds share price growth
  • Bond yields should continue to rise making 2018 a “keep your coupon” best case scenario
  • Stocks should outperform bonds for the remainder for 2018
  • Stay invested

February 2018

BBT-Perspectives-Market-Monthly-February-2018-Feature

The term “new normal” was coined during the rubble of the 2008-2009 great financial crisis to imply that normal business cycles were a thing of the past. Today, the business cycle is back in full force and “new normal” is a thing of the past. The recent correction in stock prices does not signal weakening economic conditions, but it does signify a healthy and normally functioning economy with asset prices performing on their own merits. In this edition of Market Monthly we credit the return of the normal healthy business cycle as the catalyst behind financial asset prices and their volatility. “New normal” is old news.

Summary:

Economic Update: The recent stock market correction was steep and swift but is unlikely to have a meaningful impact on the powerful U.S. economic engine. Fiscal stimulus is expected to add up to .7 percent to 2018 GDP growth. Fears of rampant inflation are overblown, but recent firm readings at a time of full employment should keep the Fed on path for three to four hikes in 2018 to avoid getting behind the curve.

Equity Update: Markets have hit the reset button after correcting over 10 percent in one of the most telegraphed corrections on record. Further market tremors are not out of the question in the near term. Earnings expectations for 2018 have surged higher since the end of 2017 raising the possibility earnings growth for 2018 will exceed market returns. Stock prices do not always follow earnings growth when valuations are high, so continued economic expansion remains the key behind future earnings growth.

Bond Update: 10-year Treasury yields have risen almost .5 percent since the beginning of the year, establishing a new trading range of 2.7 – 3.0 percent. Treasury issuance will surge as a result of increased government spending but municipal issuance remains tight. Now that bond markets have repriced to meet the Fed’s projected rate path, odds have increased that 10-year Treasury yields reach 3.25 percent by year-end.

Economic Update:

Positive Fiscal Impulse: The combined impulse of tax cuts and increased government spending are expected to boost GDP growth by .7 percent beginning in Q2. This double dose of government stimulus is happening while the economy is already operating near full capacity and unemployment is at cycle lows. This underscores the likelihood of modestly increasing inflation. However, the fiscal impulse is expected to have a 2-year shelf life and begin to wane as the business cycle matures into 2019.

A primary anti-inflation impulse is also a by-product of tax reform. Corporate tax cuts have come when profit margins are at all-time highs. This means firms in highly competitive industries who benefit from lower corporate tax rates may keep prices flat or in some cases, like Walmart, actually cut prices. Firms with pricing power will expand their competitive advantage and customers will win at the cash register.

At the end of the day, the case for higher inflation has gained traction, but it should remain contained and not spiral out of control.

Upcoming Fed Meeting:  Jay Powell delivers his first semiannual monetary policy testimony on Feb. 28th almost a month before the March 21st FOMC meeting. Markets are historically volatile early in the first term of a new Fed chairperson, so they will listen closely to his comments for signs of change. There are four key reasons the Fed will remain on course for a rate hike at its March 20-21st meeting:

  1. Economic Growth: The economy continues to generate positive data and the OECD index of Leading Economic Indicators is signaling continuing growth in the months ahead.
  2. Consensus: Recent speeches by many Fed governors reflect a steadfast resolve to stick to their plan of three rate hikes and have expressed almost a sense of relief that corrections have now reasserted themselves.
  3. Orderly Correction: The correction was steep, swift and orderly having regained much of its recent drawdown even though volatility remains elevated.
  4. Fiscal Impulse: Ongoing pro-growth fiscal policy should continue to give the Fed the “all clear” sign that interest rates need to normalize while the business cycle reasserts its strength.

Bottom Line: The tandem fiscal impulse of lower taxes and higher government spending should nudge the economy closer to the 3-percent GDP growth range in 2018. The Fed will continue to normalize interest rates so they are better prepared and equipped to act at signs of the next slowdown.

Equity Update:

The Correction: In our January 2018 Outlook edition we said once 10-year Treasury yields surpass 2.75 percent we expected to see rising rates begin to impact stock prices and compress PE ratios. We also indicated with a strong economy, any correction would be shallow and short. We didn’t expect to see it happen so quickly, but now that it has, records have fallen and the table has been reset. To differentiate between a correction (-10 percent) and a bear markets (-20 percent) consider the following since 1946:

Correction/Bear Occurrences Average Loss Duration Recovery # Recessions
Correction 25 -14 percent 4 months 4 months 5 (20 percent of Corrections)
Bear 11 -34 percent 15 months 26 months 7 (64 percent of Bears)

The recent market action was an overdue correction, and we expect to see 3 percent-5 percent drawdowns with increasing frequency at this late stage of a 9-year bull market. However, until and unless economic indicators begin to flash signs of recession, the risks of a bear market are low.

A final point of reference regarding corrections can be seen in the chart below, which shows the average S&P 500 drawdown (-18 percent) and recovery (+36 percent from the lows) for every midterm election year since 1962. Past patterns cannot be used to make predictions, but they are relevant in terms of the direction of the pattern. The deepest corrective phases in midterm years occur in the first half of the year with the largest rebound occurring during the fourth quarter.

BBT-Perspectives-Market-Monthly-February-2018-Policy-mistakes

Current Earnings Season: The Q4 2017 earnings season has surpassed all expectations so far. Consider the following:

  • All 11 sectors are reporting both earnings and revenue growth for Q4
  • 78 percent of companies are beating sales estimates (record high)
  • 75 percent of companies are beating earnings estimates
  • 127 companies have issued positive earnings guidance (record high)
  • 58 percent of firms are beating both earnings and sales estimates (record high)

Furthermore, expectations have risen substantially since Dec. 31st, 2017. Consider the chart below:

BBT-Perspectives-Market-Monthly-February-2018-SP-500-Growth

  • Q4 earnings estimates have grown from 11 percent to 15.2 percent
  • Q4 revenue estimates have grown from 6.7 percent to 7.9 percent
  • 2018 earnings estimates have grown from 12.1 percent to 17.9 percent
  • 2018 revenue estimates have grown from 5.7 percent to 6.6 percent

The trend shown above is the primary argument behind the quick and ongoing recovery from the recent correction. We expect the pace of earnings growth to slow later in 2018 and into 2019 but for now, business is good.

Stock Prices and Earnings Growth: Since 2014, the majority of gains for the S&P 500 have come from PE expansion due to the slow steady pace of Fed tightening with 0 percent as its starting line. At the current pace of earnings growth, the story for 2018 will be of PE contraction as earnings are poised to grow faster than share prices. As a result, valuations may remain elevated but not unreasonable.

History suggests that markets should not blindly extrapolate lofty earnings expectations into lofty return expectations. For example, consider the following observations from 90 years of market history as compiled by Standard & Poor’s where markets were up 61 times and down 29 times.

Market Direction
Last 90 years
Occurrences Negative EPS
Occurrences
Positive EPS
Occurrences
Double digit
EPS growth
Up 61 20 times (33 percent) 41 times
(67 percent)
29 times
(47 percent)
Down 29 9 times
(31 percent)
20 times
(69 percent)
14 times
(48 percent)

 

  • Earnings growth is positive 67 percent of the time and negative 33 percent of the time.
  • In down years, the S&P 500 experienced double-digit earnings growth 48 percent of the time.
  • In down years, the S&P 500 experienced positive earnings growth almost 70 percent of the time.

Current economic data suggests continued earnings growth for the next few years, but high earnings growth cannot promise high stock returns. Earnings are critical to stock prices, but sentiment and economic growth expectations are equally important in the late stages of a bull market.

Bottom Line: The recent correction was long overdue and driven by sentiment with concerns about rising interest rates. Additional tests and volatility are expected, which is normal. Earnings growth continues to accelerate and support stock prices as does a surging wave of share buybacks. Continued normalization of interest rates by the Fed will contribute to the renormalization of stock prices in the process as the recent correction reminds us all. The initial thrust to earnings from corporate taxcuts will begin to fade later in 2018 into 2019. Stay invested as stocks, despite their volatility, are expected to outpace bonds in 2018.

Bond Update:

Bond markets are especially impacted by the renormalization theme. Treasury issuance is expected to surge with the recent government spending package with maturities focused in the short end of the yield curve. Focus is shifting to the 2-year Treasury note as a clearer signpost for market expectations of future Fed actions. Rising inflation, as we’ve discussed, is high on the Fed’s radar of things to watch as the year unfolds. A March rate hike is baked in with increasing talk of four rate hikes for 2018.

Municipal issuance remains tight as suspected with the change in tax status for pre-refunded bonds, which have historically accounted for almost a quarter of all new issuance. This strong demand with a diminished supply has been a source of stability for muni bond buyers even during the recent correction.

High-yield bond spreads spiked during the correction but have now settled down a bit. Issuers in the lower credit grade regions of the high-yield universe will signal any early signs of deterioration and widening credit spreads. Time will tell if interest deductibility limitations in the new tax bill will lead to rising defaults for marginal issuers later in the business cycle.

Yields have quickly repriced toward where many thought 2018 would finish with 10-year Treasury yields now over 2.9 percent. With accelerating economic growth and tailwinds from fiscal pro-growth policy, rates could very well be on a path toward 3.25 percent by year-end.

Final Thoughts:
  • The business cycle is alive and well
  • “New normal” is becoming old news as the Fed unwinds its extraordinary policy
  • Existing economic growth with an incremental fiscal impulse should nudge inflation and interest rates modestly higher but with restraint
  • The Fed remains on path for quarterly rate hikes in 2018
  • Record Q4 earnings with increasing forward expectations should continue to support stocks
  • Price earnings valuations should contract as earnings growth exceeds share price growth
  • Bond yields should continue to rise making 2018 a “keep your coupon” best case scenario
  • Stocks should outperform bonds for the remainder for 2018
  • Stay invested

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors

This piece is produced by BB&T’s Wealth Portfolio Management Team.

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.