Global Dove
Let’s look at the state of the global central banks. As you can see from the chart below, most central banks’ last action was to cut rates. That’s likely because in 2015-2016 the global economy was very weak as evidenced by the decline in trade. Trade has rebounded despite the risk of protectionism. Recently, President Trump said he would probably have America exit NAFTA. We’ll see if he does that. What it is replaced with will determine how it affects trade. President Trump’s stance is very strong against free trade, but his policies and the deals he makes made don’t seem to always reflect that stance. If the stock market believed the President was against free trade, it would selloff in response to the anti NAFTA statement. The stock market sees that the global central banks loosening financial conditions has led to a growth rebound which is why it is near its all-time high. The scary part is the 6th column which shows central banks’ real interest rates. I like to look at this as a rough version of the Taylor Rule since we don’t have that for each economy.
As you can see, most of the world has negative real rates. Even America, which has rising rates, doesn’t have positive real rates. Every developed economy has negative real rates. That distorts the economy as the financial system is valuing high risk investments higher than normal. When rates rise, these high-risk investments which are getting bid up will collapse. Some would say the cryptocurrency space is driven by the desire for returns. The low yield environment has driven some investors into ICOs which don’t have real businesses. There are some instances where businesses raise capital through issuing their own currency which can buy content on their platform which doesn’t exist yet. It’s like buying tokens for a Dave and Busters which will be built in 2 years. The speculation has gotten absurd.
This global dovishness is coming to America which started it all by instituting QE. The extreme policy ideas which were exported are now being brought back. I’ve been discussing the possibility of a December rate hike, but we’re seeing the chances of any rate hikes in the next 9 months plummet. As you can see from the chart below, the chance of at least one rate hike by June 2018 is only 54.9%. Usually the Fed doesn’t raise rates unless the odds are 70% or above, so there might not be any more rate hikes this year or next year. The market has taken control over policy as it looks at the low inflation rates and lowers the odds of rate hikes. The Fed will need to be extremely hawkish to push the future expectations of rate hikes higher. These odds are partially responsible for the selloff in the dollar. This makes me worried about the short dollar trade because the Fed can use the strong Q3 GDP report as a reason to be hawkish. The most under-appreciated aspect of this chart is the fact that Trump will make his pick for the next Fed chair in February. If he picks someone more hawkish than Yellen, the dollar could rally. While President Trump says he likes low rates, the candidate with the third best odds in the betting market, Kevin Warsh, is hawkish.
Q2 Earnings Season Closes
Before we look at the final results from the Q2 earnings season, let’s review an important aspect to valuations. The most common long-term valuation metrics use either GDP or long-term earnings. I don’t like looking at any valuation metric which includes GDP. That’s because domestic GDP doesn’t fully take into account global growth as 30% of S&P 500 revenues come from abroad. Global GDP compared to global markets doesn’t account for the various economic setups. China doesn’t have a free market which lets corporations fully benefit from the economic growth. That alters global valuations. Another factor which affects American markets is the corporate tax rate. Taxes paid are low now in America despite the high statutory tax rate meaning stocks have high earnings relative to GDP which won’t necessarily mean revert. I think the best long-term valuation metrics look at normalized earnings. The only way to accurately take into account the economic system in China or any other country is to compare long term earnings multiples to the past.
The Shiller PE is the most common long-term earnings valuation metric. It’s not the best one as there are many alterations which can be made to improve its prediction accuracy. One way to fix the Shiller PE is to use better earnings growth rates which accurately reflect reality. The chart below shows the 20-year and 10-year average S&P 500 compound annual growth rate. As you can see, the recent average growth rate isn’t the 7%-8% you normally see. The recent real growth rate average is slightly below 4%. The long term real earnings growth rate is 1.7%.
Next week, we’ll go back to looking at the great FactSet charts. For now, we only have the S&P Dow Jones results. Unfortunately, there was a mistake in the data which means it isn’t showing the S&P 500’s margins, so we’ll review that next week too. With 97.8% of firms reporting earnings in Q2, the trailing twelve month as reported earnings were $104.05. That is the $1.91 below the record. The next quarter is expected to have $108.06 in twelve- month earnings which would be a record. We are ending the 2ndmonth of Q3 with the dollar index at a $92 handle which should support earnings. 68.9% of firms beat sales estimates and 70.45% of firms beat earnings estimates. Telecom and energy had the lowest beat rate. Telecom only has 4 firms making it not an important data point. Energy was weak because of lower oil prices. Technology and healthcare had the highest beat rate.
Besides the growth in margins moderating, the buybacks are also declining, hurting earnings per share. This makes sales growth even more important to second half earnings results. I haven’t highlighted the decline in buybacks much in previous articles because I think the trend will reverse in the next few quarters, but it’s important to recognize the Q2 results are especially strong when you realize buybacks didn’t help EPS as much as they had last year. That shows how bad last year’s earnings per share results were as they declined despite the buyback tailwind.
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