Global growth continues to exceed expectations. This global synchronized surge produced higher-than-anticipated earnings both in the U.S. and abroad. Higher earnings, new highs in global growth, and stable intermediate-term interest rates have combined to propel stocks to record levels. But have the world’s stock markets fully priced in the good news? Will changing monetary policies undermine the price-to-earnings multiple expansion we are witnessing? Could tax policy changes provide an additional boost to stock prices? This installment of Investment Strategy explores these questions.
Earnings Elevate Stocks
Some investment strategists believe that the present bull market in stock prices began in March 2009. Others believe that stocks went through a sector-by-sector rolling correction from mid-2015 to mid-2016. As shown in Figure One, the earnings of U.S. public companies went through a stall or correction for seven quarters, beginning in the second quarter of 2015 and ending in the first quarter of 2017.
Figure One—S&P 500 Trailing 12-Month Year-Over-Year Earnings Growth
So, while the bull market in stock prices might be years in duration, the revivification of earnings is just two quarters old. Perhaps that is why the market continues to underestimate earnings growth and be pleasantly surprised by earnings increases this year.
Stock prices climb when reality exceeds expectations—as is happening now. This earnings surprise is evident in the U.S. markets, but the surprise is even more dramatic in Europe. Figure Two shows the year-over-year growth in the earnings of European companies climbing from nearly 0 percent in the fourth quarter of 2016 to nearly 35 percent in the second quarter of 2017. We believe this performance premium—driven by revived earnings growth—is sustainable for the next year or two.
Figure Two—Stoxx 600 Trailing 12-Month Year-Over-Year Earnings Growth
Stocks also continue to be bolstered by buybacks. Figure Three, which we showed last quarter, demonstrates companies’ unabated demand to buy back their own shares. For the past several years, firms have spent as much as 75 percent of their earnings for buybacks to the tune of approximately half a trillion dollars a year. In fact, these corporations themselves have been the only net buyers of stocks over the last eight years; individuals have, in aggregate, not invested any new dollars into the stock markets.
Figure Three—Stock Buybacks (in $ billions)
Earnings are higher because growth is solid. Figure Four shows the JPMorgan Global Manufacturing Purchasing Managers Index hitting a new high. The synchronized global growth spurt is lifting production, consumption, and earnings at a faster-than-expected pace. With the recovery in energy prices, corporate investment in plant and equipment is starting to increase too. We are enjoying a self-perpetuating sweet spot at present. However, rising rates have the potential to interrupt this cycle.
Figure Four—JP Morgan Global Manufacturing Purchasing Managers Index (2014-2017)
A Threat to Stock Prices?
Very low interest rates may have induced economic growth—boosting stock prices and consumption—but will the euphoria dissipate as interest rates return to higher, more normal levels?
Major central banks lowered short-term interest rates to near 0 percent during the recession. Worried that extraordinarily low short-term rates were not enough of an economic stimulant, they also began buying intermediate- and longer-term government bonds in a quest to reduce rates, particularly mortgage rates, to induce new home construction. The collective amount of their bond buying is staggering.
Figure Five—Cumulative Central Bank Balance Sheets vs. the S&P 500 (January 2002-June 2017)
The Federal Reserve began its quantitative easing policies (including balance sheet expansion) in 2008. These policies continued to expand the Fed’s balance sheet until early 2014. Since then, the Fed has maintained its balance sheet size by reinvesting maturing bonds. Figure Five details the magnitude of central bank bond buying and balance sheet expansion alongside the price level of the S&P 500 index. Looking at this chart, one might conclude that the stocks of the S&P 500 Index—and global stocks more generally—have been boosted by central bank actions.
Looking again at Figure Five, one could also argue that since the Fed stopped increasing its balance sheet three years ago, any subsequent increase in stock prices was not related to easy monetary policy in the U.S. Others will cite the increase in foreign central bank balance sheets—specifically the European Central Bank (ECB) and the Bank of Japan (BOJ)—as a further stimulant to U.S. stock prices. If the latter argument proves conclusive, then the recent change in U.S. monetary policy should not impact stock prices and intermediate-term interest rate levels (like mortgages) in the U.S. because both the ECB and the BOJ are continuing to expand their balance sheets.
We agree with the latter position. A Fed policy change, by itself, will not overly impact mortgage rates or stock prices unless and until the fed funds rate rises above the yield on the 10-year U.S. Treasury Note. Therefore, policy changes by the ECB and the BOJ could have the most influence on stock prices. We are keenly focused on changes in monetary policy by the ECB and the BOJ as catalysts for the market.
Impact of Changing Monetary Policy
Stock prices are determined through a combination of fact and emotion. Investors know recent reported earnings, and they estimate earnings growth and the interest rate used to discount future earnings to a present value—otherwise known as a stock’s price—today. This is the fact side of the equation. Meanwhile, investor emotion is said to swing like a pendulum between the extremes of fear and greed, causing investor confidence and sentiment change over time. This means that investors will pay a higher or lower price for the same stock with the same earnings growth rate depending on prevailing sentiment. As a result, the market can be driven by any combination of a change in sentiment, interest rates, or earnings.
At present, earnings are surpassing expectations, sentiment is bullish, and intermediate-term interest rates are stable. The main driver for stock prices, right now, is the upward change in earnings. A change in monetary policy that leads to a much larger increase in intermediate-term interest rates could trump earnings as the market’s driver, but the Fed has moved slowly to change rates and has been very transparent, telegraphing its policy changes well in advance. It has successfully set expectations for interest rates changes. As a result, we do not believe that an increase in short-term interest rates will derail investor sentiment.
To put the current bull market into perspective, we looked at stock market performance from market bottoms back to the 1930s. Figure Six demonstrates that, although the first five years of this bull market run—from 2009 to 2014—produced strong returns, we do not believe that the price appreciation experienced is mostly due to very low interest rates. If it were, we would expect to see this bull market as the greatest ever. Instead, it ranks as the third (nearly the fourth) best of the last 13 bull markets.
Figure Six—Stock Market Five-Year Cumulative Performance from Market Bottoms
We hold that as long as the 30-year mortgage rate stays at 5 percent or below—it’s currently 4 percent—then economic growth can remain solid, and earnings can continue to grow enough to push stock prices higher. Figure Seven demonstrates that, while short-term rates have risen, so far they have not impacted mortgage rates.
Figure Seven—Fed Funds and Mortgage Rates (2007-Present)
Impact of Rising Rates
We expect the Fed to raise the fed funds rate from 1.25 percent—where it sits today—to 2.5 percent by the end of 2018. We expect the 30-year fixed-rate mortgage to increase to 4.87 percent.
Rates could increase further if we experience inflation higher than 3 percent. A number of factors, including wage increases and commodity price shocks (like during the oil embargo of the early 1970s), could drive inflation. But at the moment inflation is quiescent.
Wage inflation has increased over the last five years from an annual rate below 1.5 percent to 2.5 percent today. If wages begin to increase at a rate greater than 4 percent annually, we would expect both short- and long-term rates to increase more rapidly. The Federal Reserve typically increases interest rates late in a business cycle to dampen rising inflation. Additionally, when short-term rates exceed long-term rates, both stock market gains and economic growth are in jeopardy.
An increase in short-term rates favors savers and harms borrowers. Higher credit card bills, for example, should dampen consumer spending on items such as dining out and clothing purchases. Given that consumer spending accounts for 70 percent of U.S. economic activity, the need to divert income to pay higher interest charges must, therefore, reduce potential consumption.
The good news is that we also predict more than a 2.5 percent increase in wages. This extra income is more than five times the amount needed to pay the higher interest costs resulting from a 1 percent increase in short-term rates for the nation as a whole. However, some consumers are more burdened with floating-rate debt than others. For them, a 2.5 or more percent wage increase may not be enough to offset their higher interest costs.
One wildcard on the horizon is the Trump tax plan. As outlined, it would provide huge tax cuts for middle- and upper-income Americans and create a correspondingly huge increase in the budget deficit.
While we do not believe that much of the Trump proposal will become law, there is bipartisan support for a reduction in the corporate income tax rate and for a repatriation of overseas profits. If these two provisions are enacted, stocks could increase another 6 to 9 percent next year.
To conclude, stock prices are high, driven by excellent earnings growth and stock buybacks. For now, at least, this provides sufficient support for the stock market, even as we witness a marked change in U.S. monetary policy. The expected increase in short-term rates should not prove a significant risk to the market in the near future. Of course, investors should also expect periodic upticks in stock market volatility or even a market pullback, which can stem from many places, including political and geopolitical uncertainty. As always, we advocate for diversified portfolios that include U.S. and international stocks and bonds, as well as non-correlated assets that can perform well in any market.