Equities: Short-term positives, but headwinds gathering

Sunflower – Post Malone & Swae Lee, 2018

With the third quarter earnings reporting season behind us and investors looking at what’s ahead for equities, it is helpful to distinguish between short-term and longer-term factors. Over the short term, the context for stocks looks supportive, if perhaps less so than it did a couple of months back. However, pressures are building that may become significant headwinds for some firms. Though it is difficult to know when these pressures will hit a tipping point, in our view it seems too early for callin’ it quits, thinkin’ in a bad way, losin’ your grip.

What’s Next?

Short-term factors remain positive

The third quarter of 2019 was a difficult one for firms. For constituents of the S&P 500 index, aggregate sales grew by 3.6% over the previous year but earnings were down 1.0%. Firms in the STOXX Europe 600 index saw their aggregate sales up slightly at 1.0%, but earnings growth was flat at 0.2%. Profit margins contracted further, though they remain elevated for both regions (10% for the S&P 500, 7% for the STOXX Europe 600). Interestingly, increased costs were mostly attributed to higher tariffs rather than wage pressure or other typical causes as firms looked to have absorbed the impact of the trade war on their profit margins rather than increase the prices of their goods.

However, market moves are based on expectations, and the low expectations going into the earnings reporting season helped support stocks: 79% of firms in the S&P 500 had a positive earnings surprise, while for the STOXX Europe 600 the figure was 57%. While earnings expectations for 2020 are on the high side (10% globally), they are relatively muted for this year (under 1% globally, with the US a bit above 1%), indicating that a strong finish to the year would be a modest positive surprise for the market.

However, we are keeping an eye on long-term factors

While the picture for stocks looks fairly positive to us in the near term, there are clouds gathering on the horizon we are closely watching. First, monetary policy has been the major tailwind for stocks this year. For instance, EPS for firms in the S&P 500 have been essentially flat this year, while the 10-year bond yield has fallen about 100bps. Holding the equity risk premia constant, this change in the discount rate would imply about a 20% price return, accounting for nearly all of the 24% return on the S&P 500. However, barring a significant economic slowdown in 2020 (which is not our base case), monetary policy looks likely to be on hold for most of 2020, removing an important support for equity markets.

Easy financial conditions have allowed firms, especially in the US, to finance themselves via borrowing at low rates. For much of the post-GFC expansion, this higher leverage was offset by rising profits. Thus, while net debt for the Russell 3000 index on aggregate has grown consistently every quarter for the last five years, it has remained at about 1.5x EBITDA steadily until the last couple of quarters, when it hit 2x as net debt growth outpaced profit growth. Of course, the aggregate picture can obfuscate pockets of risk, but when we look more granularly, the picture is concerning but not worrisome: since 2010, net debt as a multiple of EBITDA has picked up for US firms but remains below the levels seen before the GFC. Indeed, the median firm’s net debt is now 2x EBITDA, but that is well below the 3.5x multiple it averaged from 2002 to 2006. The same picture holds for firms’ interest coverage ratios – they have deteriorated but are not alarming. However, if these trends continue, either due to more borrowing, higher interest rates or declining earnings, investors may start to question the ability of firms to maintain profitability in the face of their debt obligations.