Byron Wien: Triumphant Equity Returns Are Over
We are growing accustomed to wide daily swings in the Standard & Poor’s 500 and the Dow Jones Industrial Average. Triple-digit moves in the latter and double-digit changes in the former are no longer reasons for elation or alarm. The volatility can result from an unexpected economic report or a tweet from the White House. Big moves in either direction are usually followed by opposite moves and year-to-date the indexes are basically flat. In the first quarter, the S&P closed in excess of 1% in either direction 23 times, a rate exceeded only in the volatile years of 2008 and 2009. These were periods in which the market returned -37% and +26% respectively. At the beginning of the year I thought sentiment was euphoric and equities were ripe for a 10% correction. We have now had that correction and investor sentiment has changed from euphoria to concern. In my opinion, however, sentiment is not yet at a point which would support a sustained positive move in the market.
In the meantime, there has been a shift in some of the fundamental factors that influence equity prices. The disappointing payroll report for March indicated that the economy may be losing some of its momentum. The Institute for Supply Management reports for both manufacturing and services are still positive but showing signs of rolling over. European industrial output declined for the third consecutive month. Delivery times are becoming extended, indicating that companies are under pressure, which usually leads to a rise in product prices. Personal consumption expenditures have bottomed and prices are headed higher. So far this has only had a moderate impact on interest rates. The 10-year Treasury yield has reached a peak of 2.98%. Data from the Investment Company Institute suggests investors have been withdrawing funds from U.S. equity mutual funds and ETFs and placing the proceeds into the perceived safety of fixed income investments. Some of the largest flows have been going into longer-duration funds. The China / U.S. trade dispute has caused some investors to reprice growth expectations. China, the world engine for growth, was already slowing its economy down to deal with the non-performing loans on the books of its banks.
I remain of the view that 2018 will be a positive year for equities, primarily because of performance in the second half and driven by earnings growth. The tax cut should enable the S&P 500 to come in with earnings of $160 in 2018. At current market levels, the index is only at about 16 times earnings, which is favorable at present interest rates. If yields rise or the earnings outlook deteriorates, the prospects for equities would change, but signs that this shift is about to happen have not yet appeared. I still believe a recession and/or a bear market is at least two years away.
There are, however, some larger issues worth exploring. The first is debt at the Federal level. In the year 2000, total U.S. government debt was $6 trillion and the blended interest rate (or debt service) was about 6% or $360 billion. Today, the debt is $20 trillion and the debt service is about $450 billion or about 2.25%. So the debt has more than tripled but the debt service has only increased 25%. If the economy were growing at 3%, you would think the policy makers in Washington would recognize that a favorable economic period is a good time to reduce the debt or, at least, not add to it. Unfortunately, that is not what is happening. The Tax Cut and Job Creation bill will probably increase the existing budget deficit from $700 billion to $1 trillion annually.
That, however, isn’t the key problem. The principal buyers of bonds have been the Federal Reserve, China and Japan. We know the Fed has an objective of reducing its balance sheet, and China and Japan may be buying fewer bonds in reaction to the increase in tariffs. We have a situation, therefore, where the major buyers of U.S. Treasuries will be accumulating fewer bonds and notes while the Treasury is issuing more. While under these circumstances you would expect rates to rise, so far that hasn’t happened.
One can reasonably wonder why there isn’t already more interest in U.S. sovereign debt. The United States is the largest economy in the world and its debt has proven reliable for repayment for more than two centuries. Interest rates are higher on that debt than they are on that of Japan or any major industrialized country in Europe. One factor which may be discouraging foreign investors from buying our Treasuries is the dollar. As I have noted, our annual budget deficit is increasing and so is the trade deficit. An increase in both these deficits should put further pressure on the dollar and make foreign buyers less willing to buy U.S. debt, thereby causing interest rates to move higher. I do not expect the rise in rates to be large but could still see a move to 3.25%–3.5% in the 10-year Treasury over the next year.
Non-financial business debt is another issue that should be explored. In 2000, U.S. companies had $6.5 trillion in debt outstanding. That number has, according to the Federal Reserve, grown to over $14 trillion in the most recent reading. But so far, because of low rates, the interest expense hasn’t been a burden. Spreads between investment grade and high yield are near similar levels, but in 2000 the 10-year Treasury had a yield over 6%. According to the Bank for International Settlements, nearly 16% of companies in the U.S. and 10% in both the Euro area and the U.K. can’t cover their interest payments today (interest expense exceeds earnings before interest and taxes). This is almost double the rate exhibited in each country in 2000. And that is in a historically low-rate environment.
Growing inflationary pressures could complicate the relationship between increased Treasury supply and a shrinking base of buyers. Core CPI in the U.S. accelerated to 2.1% in April. The jobs market continues to tighten while wages are again on the rise, up 2.7% year over year. In addition, oil prices recently crossed over $66/bbl, up almost 30% in the last 12 months. My view is that the Saudis want to see oil hit $80 in order to sell a stake in Aramco. Higher oil prices have also had an impact at the pumps. According to AAA, unleaded gas prices in the U.S. are up 11% in the last 12 months from $2.39 to $2.66 per gallon. In 2017, over 143 billion gallons of gas were, according to the Energy Information Administration, consumed in the United States. In a late-cycle environment, nearly all the traditional sources of inflation are slowly starting to rise. Inflationary pressures will negatively impact both equity and bond portfolios.
Another concern I have regarding rates relates to the U.S. economy itself. If growth were at 3% real, you would expect to see more capital spending, even though capacity utilization rates are below 80%. Extended delivery times is a sign that capital investment is about to happen. We also know that technology is encouraging companies to modernize their equipment. Many companies will use the tax cut to increase dividends and buy their own shares back rather than for capital expenditures. As a result, they will borrow the money they need for capital expenditures, and this will put further pressure on interest rates.
The rapid turnover of staff, particularly at top foreign policy levels, in the White House may also be a negative factor in the longer term. So will the tendency of the administration to change its mind on key issues such as troops deployed in Syria, NAFTA, and other policies. Foreign buyers of our bonds generally like to believe that they are dealing with a counter-party that won’t modify its position on important matters abruptly. In addition, there are some major policy decisions that could have an impact on the economy over the remainder of the year. For example, the proposed summit meeting between Kim Jong-un and President Trump carries both risks and opportunities. Because the agreement to meet was instituted at the head-of-state level, we have to hope that there will be adequate time for staff preparation by the State Department and other government agencies in advance of the meeting. Second, there is general agreement among our partners that the restraints on nuclear development in Iran are working. While some adjustments would be constructive, abandoning the agreement would probably be a mistake. Still, a withdrawal is a possibility, given President Trump’s negative comments about the deal. Angela Merkel and Emmanuel Macron have come to the U.S. to convince Trump to stay in. A breakdown of the agreement would further destabilize the Middle East, raise the price of oil and have a negative effect on the world financial markets. We also need to worry that the daily increase in tariffs by one side or the other will lead to an all-out trade war, which would be a serious market negative. So far the rhetoric has been loud but the dollar amounts have been small. This could escalate, however, if we see successive tariff increases.
If you think about all of these and other major issues, every one of being resolved favorably is unlikely. A trade war could slow the economy down; the North Korea / United States nuclear negotiation could result in an increase in the possibility of a military confrontation; withdrawal from the Iran agreement could sour our relations with the other partners to the pact; pulling out of NAFTA could put tens of thousands of Americans out of work; military action in Syria in response to the regime’s use of chemical weapons could aggravate tensions in the Middle East. Right now, the equity market is assuming that these background factors will not impact the financial markets but that view may be too optimistic.
Finally, I have some concerns about how the financial markets could be impacted over a longer timeframe. I worry that the administration is focused on current problems, which are considerable, but not dealing with longer-term issues. Foremost is our failure to improve our educational system, putting us at economic disadvantage over time. We have not been able to increase the high school graduation rates (now about 75%) in our public education system and our test scores in reading, mathematics and science are in the lower half of the OECD universe. Future jobs will require workers with more skills and, in spite of considerable effort and money, we are not making major progress here. Second, I worry that China is going to take the lead away from us in technology. Next year for the first time the Chinese will be spending more on research and development than we are. They are making major strides in information technology and biotechnology. Many Americans believe China is good at manufacturing but steals technology from others. That may have been true in the past, but their innovation skills are growing and over time that could threaten us economically. In 2016, China graduated 4.7 million students in STEM subjects (Science, Technology, Engineering and Math) compared to 568,000 in the U.S., according to data from the World Economic Forum.
I also continue to be concerned about U.S. growth over the long term. Historically, real growth has been the sum of population increases and productivity. Right now both of these are running below 1%. This means our future growth rate, after the tax cut and fiscal spending boost, could settle back to 2% or below. That would not be good for the financial markets.
For all of these reasons, I believe that beyond this year stock and bond returns will disappoint those investors who have become accustomed to the higher returns achieved earlier in this bull market. Future returns for the S&P 500 will be in single digits. With interest rates likely to increase, future gains in the broad indexes will be the sum of earnings gains and dividends. I expect earnings gains to be roughly equivalent to the nominal growth of the economy of 4%–5% and dividends to be about 2%, for a total of 6%–7%. That is consistent with the long-term appreciation of the S&P 500. I still have year-end 2018 target of 3000, but the extended period of multiple expansion as bond yields have declined is over. Bond returns will be muted as well. The 30+ year bond bull market is over. If the 10-year Treasury bond yield rises to a level of 3.25%–3.5%, then many longer-duration fixed income assets will underperform.
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