Topics: Another year of American exceptionalism in equity markets, tempered by the tech-dependence of equity returns, high valuations, fading stimulus and constitutional/tariff risks; Italy and “Europartenza;” golden era for U.S. commercial property closing.
America, first. Most signs of the U.S. expansion still look healthy: Business surveys are strong and while rising Fed policy rates are starting to cool housing and autos, other household purchases and the business sector have more than offset the drag. Q2 2018 was another stellar quarter for U.S. earnings compared with the rest of the developed world, even without the benefit of U.S. corporate tax cuts. A sharp upward revision in the U.S. personal savings rate also paints a picture of a healthy household sector.
While P/E multiples for the tech sector are higher than for the market (28x vs 21x, trailing), the gap isn’t that large given superior tech earnings performance. To me, the risks are related to investor crowding,2 “earnings beats with poor guidance,”3 and high absolute valuations: While P/E’s have come down since the start of the year, the S&P 500 index still trades at the 85th percentile of expensiveness versus its history, and the median stock trades even more richly, at the 96th percentile.
The bottom line for investors in U.S. equity markets in 2018: positive returns, but at a rate below the pace of earnings growth as P/E multiples decline.
I think that’s what we will see next year as well (our earnings expectations for 2019 are 10% to 12%), for reasons outlined below. I don’t think the risk of contagion from emerging markets to developed markets is very high, given the substantial changes in the EM balance of payments landscape over the last 20 years.4
Trump is also moving forward with restrictions on Chinese investment in the U.S.A bipartisan bill signed in mid-August allows the U.S. Committee on Foreign Investment (CFIUS) to block non-controlling foreign investments via venture capital funds in “critical, emerging and foundational technologies,” such as robotics, artificial intelligence, self-driving cars, cybersecurity and big data. The risk of expensive and complex CFIUS reviews is already reportedly discouraging some U.S. venture capital funds from accepting Chinese capital, creating downstream risks for a U.S. equity market highly reliant on the tech sector.
U.S. commercial real estate golden era gradually ending
One last topic. The last decade has been stellar for U.S. commercial real estate: low interest rates, tight credit spreads and demand for office, retail and industrial space that consistently outstripped new supply. Supply-demand dynamics have shifted in recent months, such that demand is now roughly equal to supply. When combining these trends with rising interest rates and the risk of rising spreads, I would not be surprised to see plenty of commercial property supply coming online over the next year.
1There are signs that U.S. apparel, auto and manufacturing companies are exploring the idea of migrating production out of China to other Asian countries. Tariffs are starting to show up in some analyst earnings projections for 2019, but very tentatively given the lack of specifics.
2A prime brokerage report covering 830 hedge funds found that a record 28% owned Facebook in Q3 2018; that tech is the largest sector weight; and that the five most common positions are FB, AMZN, MSFT, GOOGL and NXPI.
3FB and NFLX beat EPS targets, but FB provided weak margin guidance and NFLX reported weak subscriber growth.
4As we wrote in back in May, Turkey is only 0.9% of the EM equity index and Argentina is not present at all, having been exiled to the MSCI Frontier Equity Index alongside Lebanon and Kenya; the Turkey/Argentina headlines are not commensurate with the amount of investor capital at risk. Furthermore, the large current account deficits of Argentina and Turkey are no longer representative of the EM universe, many of whom run a surplus, are much less reliant on foreign capital and hold higher levels of FX reserves relative to external debt. While EM returns are negative this year, I don’t see the kind of contagion risks for developed market investors that were present in the 1980s, in 1998 or in 2001.
5The yuan has already depreciated by 8% since May. On potential sanctions, the revenues of U.S. companies operating in China are equal in size to the entire U.S. trade deficit with China [EoTM May 30, 2018].
6When Nixon was reviewing the evidence against him during the Watergate investigation, the Secret Service disabled the “erase” button on his recorder, and as additional measure, provided tapes that were duplicates of the originals.
7When Fed Chairman Arthur Burns resisted pressure from Nixon to guarantee full employment during the 1972 Presidential campaign, the White House planted negative stories about Burns in the press. Nixon’s people also floated stories about diluting the Fed Chairman’s power by doubling its Board’s members. Nixon wrote to Burns: “There is no doubt in my mind that if the Fed continues to keep the lid on with regard to increases in money supply and if the economy does not expand, the blame will be placed squarely on the Fed.” In 1971, H.R. Haldeman spoke about the effectiveness of Nixon’s strategy: “We have Arthur Burns by the [expletive] on the money supply.”
8“Italy Autumn Heatwave Warning,” TS Lombard, August 22, 2018.
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