MARKET COMMENTARY

The Bottom Line: Fundamentals Over Fears

09.20.2018 - Ronald J. Sanchez, CFA

KEY TAKEAWAYS
  • Fiscal Policy Boosts Earnings and Supports Equities 
    Lower taxes, deregulation, and repatriation are freeing up cash for companies to spend on shareholder-friendly buybacks and M&A, which support the US equity market.
  • Trade Tensions Present Risks, but Keep Them in Perspective
    Tariffs could threaten global supply chains, GDP growth, and equity prices. But so far, US fundamentals have been strong enough to prevent them from upending the market.
  • A Rising Tide Lifts Some Boats More Than Others
    Fiscal stimulus is increasing return dispersion, separating winners from losers, and rewarding investors who actively select the right stocks.

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Despite strong economic growth and corporate performance, 2018 has not necessarily been a year of smooth sailing. At several points, a protracted bull market and future economic growth both appeared to be threatened by the prospects of a global trade war, friction between the US and its closest allies, and other geopolitical concerns. The risks are noteworthy, with the potential to disrupt global supply chains, which could affect economic growth, and by extension, asset prices. 

However, in the tug-of-war between trade-related concerns and fundamentals, the pull of positive corporate and economic data has been stronger than trade-related headlines. Investors have ultimately focused on fundamentals and are reaping the rewards.

In our view, the market’s solid performance to date is due largely to two factors: Corporate profits are on track to expand a staggering 23% this year, and economic growth in the US is poised to break through the 2% trend, a muddle-through level that has been a hallmark of the post-crisis experience.

With less than four months remaining on the calendar, the S&P 500 is once again on pace for double-digit returns. If it continues along this path, 2018 would mark its eighth year of accomplishing this feat in the past decade.

Tax Reform Boosts Earnings
As the year progresses, economic data and corporate financial reports are beginning to offer concrete evidence that recent policy measures, including tax reform, are boosting growth and earnings.

If we drill down into the effects of fiscal policy, we can measure the impact tax reform is having specifically on the bottom line as corporate taxes fall from a rate of 35% to 21%. Earnings are on track to grow 25% in the second quarter of 2018 versus the same period last year, and tax reform is expected to provide the S&P 500 with a 7% earnings boost (CHART 1), driving calendar-year earnings growth to 23%.

                

But even when the effects of tax reform are removed from the equation, earnings projections reach roughly 16%. That still puts the US ahead of every other developed market in the world and represents an acceleration from the 5.1% average annual growth rate we have seen over the past four years.

At the macro level, stimulative policy measures beyond tax reform helped propel the US economy, which expanded at a rate of 4.2% in the second quarter, its fastest pace in three years.

It seems evident to us that all these measures have helped re-establish the US as the primary driver of corporate profits and economic growth in the developed world. In fact, earnings were already gaining momentum before the tax code was overhauled in late 2017. But the data suggests tax reform is amplifying this growth in a meaningful way.

Will Companies Reinvest?
Looking ahead, one of the most important questions for markets and the economy is what companies will do in the coming year with the record profits they are generating at home and the offshore earnings they will repatriate.

While survey data suggests a future improvement in capital expenditures, contributing to a sustained pickup in economic activity, trade policy uncertainty could make CEOs reluctant to approve new spending. So far, corporations have preferred to return capital to shareholders through buybacks and increased dividends. Buyback authorizations are estimated to total a whopping $1 trillion in 2018, which would be a single-year record and represent roughly 4% of the S&P 500’s entire market capitalization.

Tax reform is also freeing up capital for mergers and acquisitions. By the end of July, companies had already announced plans to spend a cumulative $1.8 trillion this year, breaking previous records.

So far this year, executives appear to be allocating much of this newfound capital to record-breaking buybacks and M&A activity. These decisions may not move the needle for the US economy, but they could provide the US equity market with additional support through the end of 2018 and beyond, possibly contributing to further price appreciation and extending the life of this resilient bull market.

Repatriation Could Buoy Tech Stocks
Companies with large overseas cash balances could be the biggest beneficiaries of tax reform, thanks to a repatriation provision that requires them to bring those earnings back to the US at a one-time, discounted tax rate as low as 8% for some firms. The five largest holders of offshore earnings are all tech firms (CHART 2) and technology is the best-performing sector so far this year, returning more than twice as much as the market. 



Moreover, when we compare indexes that factor in each company’s market capitalization to indexes that are not weighted, we see additional evidence that the largest firms are benefiting more from fiscal stimulus and making outsized contributions to market returns. For example, the market-capitalization-weighted S&P 500 Index is on pace to return 4% more than its equal-weighted counterpart this year. That would represent the widest margin of outperformance in the past decade.

We appear to have shifted from a “beta” market environment, where a rising tide lifted all boats, to an “alpha” cycle, where selectivity and fundamental analysis are making more significant contributions to performance.

Are Stocks Priced for Perfection?
Clearly, fiscal stimulus is contributing to stronger corporate results. In the second quarter, roughly 70% of S&P 500 companies beat sales estimates and 83% beat earnings forecasts. It has also raised near-term market expectations considerably. While the average market valuation still seems reasonable, some companies appear to be “priced for perfection” and investors are quickly punishing them for missing sales and earnings targets. On average, their stock prices fell 6% the day after a disappointing earnings report (CHART 3). 



On the other hand, the initial reaction among investors is to offer only modest rewards for companies that beat sales and earnings projections. Stock prices for companies that exceeded both top-line and bottom-line expectations gained an average of only 2.8% the day after an upbeat earnings report.

This asymmetric reaction illustrates lofty expectations, increasing the risk of disappointment. An extreme response to an otherwise solid earnings report suggests the market has priced that stock for perfection. The margin of error for firms in that position is slim, and the margin of safety for an investor holding the stock is equally narrow. 

Keeping Trade Policy in Perspective
While the “knowns” related to fiscal policy are positive for the market, the “unknowns” accompanying current trade negotiations are not. To date, the Trump administration has announced three rounds of proposed tariffs aimed at China. The total value of goods to be taxed in the proposed actions is $450 billion—a number regularly referred to in media coverage.

However, it is important to keep in mind that the actual tariffs levied on that $450 billion worth of goods would be much lower if they went into effect, roughly $52.5 billion. Midway through August, only $12.5 billion in tariffs had been implemented, with the balance still in the proposal stage.

Putting this in perspective, the US economy is expected to expand by $1.1 trillion this year. If all $52.5 billion in proposed tariffs were enacted, they would represent just under 5% of nominal GDP growth in 2018. In the context of the current policy suite of tax cuts, deregulation, government spending and repatriation, tariffs are relatively small. In fact, the combined value of these measures should top $1 trillion.

In summary, while the potential domino effect of tariffs is nearly impossible to quantify, the headline numbers pale in comparison to the expected benefits of the stimulative policies enacted by the government over the past year, as well as the expected growth of the US economy.

The Bottom Line: Fundamentals over Fears
While much remains uncertain on the trade and geopolitical front, what is clear is that both the US economy and corporate backdrop are on solid footing. The benefits of fiscal policy have helped lift corporate profits, support economic growth, and fuel gains in the equity market. Assuming the trade conflict doesn’t escalate, we believe markets will continue to focus on strong corporate and economic signals and reward companies that have strong fundamentals.

That’s not to say we believe 20% earnings growth and 4% economic growth is the new trend. Market returns have exceeded earnings growth for several years now, and this trend is unlikely to continue in the years ahead. Still, we believe returning to a more “normal” growth rate for both earnings and the economy would bode well for the life of this lengthy equity bull market. Even if 2018 proves to be the peak in earnings, we still see a constructive environment ahead for US equities.

Lastly, shifting government policy—from monetary to fiscal—is contributing to greater market differentiation, drawing a sharper line between winners and losers. This should usher in a new regime where alpha opportunities are more prevalent and just “owning the market” may not prove as fruitful as it has for much of this post-crisis cycle.


This communication is intended solely to provide general information. The information and opinions stated are as of September 19, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA institute.

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