Columbia Threadneedle: US Equities, the recessionary cloud is about to lift
The dominant theme as 2019 began – following three months of steep falls on world markets – was recession. But this threat was not obvious to us. Markets were pricing a downturn that we could not see in the data and, as a result, it seemed a good time to add to US equities: volatility was too high and assets too cheap.
Our view turned out to be correct, even if the scale of the price action that followed took us by surprise. By March the S&P 500 index had risen around 21%1from its low as two major overhangs that had weighed on sentiment started lifting. First, the US and China agreed a truce in their trade hostilities in December, and then in January Fed chairman Jay Powell signalled an about-turn in monetary policy. Having raised rates in December, the following month Powell said the Fed was open to cutting.
The rebound loses momentum
However, the sharp first quarter rebound in US equities lost momentum and the dominant recessionary theme reasserted itself. Soon after the first Fed rate cut, in July, fears of a downturn intensified and sections of the US yield curve inverted, traditionally seen as a recession indicator. But again, we believed the fear was overdone. Other indicators including employment, the housing market and credit spreads did not corroborate such an outcome. We felt the inversion mainly reflected the Fed’s tightening in 2018 at the short end of the yield curve, and that the signalling power of the yield curve at the longer end was less clear than people assumed.
The other important features of the year that we did not anticipate – and that fuelled the recession theme in the second half – were the arrival of an industrial recession as the inventory cycle turned, compounded by trade war, the resulting strength of the dollar, GM strikes and the Boeing 737 Max grounding.
The manufacturing cycle turns down
2019’s contraction in manufacturing and industrial output is the third we have seen in the current economic cycle, following downturns during 2011-12 and 2016. The latest dip was clearly influenced by dollar strength, the ongoing trade war between the US and China, and the impact of both GM strikes and the grounding of Boeing 737 Max. Although the trade war remains unresolved, we believe the bottom of the inventory cycle is close.
Earnings forecasts for S&P 500 companies were sliced and, in some cases, companies missed their downgraded numbers, with the energy sector for instance now on track for a 27% drop in 2019 earnings. Inevitably, fears grew that the US market might be entering an earnings recession, which historically has always coincided with an economic recession. At the top level, however, the picture was being distorted by idiosyncratic issues at several companies with large index weightings including Facebook and Google, both of which have seen big one-off increases in costs that have temporarily held back their earnings.
A rosier picture behind the headlines
Looking beneath the surface, median earnings growth was significantly better than the index suggested, and revenue growth remained buoyant, with domestically-focussed companies performing particularly well. Against a background of excessive pessimism, we stayed positive and maintained our positioning.
Thinking about 2020, we expect earnings growth to resume towards the long-term trend rate of 5-7%, with faster growth possible if a substantive trade deal with China is agreed. We anticipate GDP growth will slow from this year’s rate of around 2.2% to about 1.8%, bringing it back in line with its longer-term trend. Although the S&P 500 has gained around 23% over the past 12 months, the forward price/earnings ratio is within a standard deviation of its long-term historic average, albeit at the high end.
China détente likely, but trade tensions persist
Even so, November’s presidential election remains a major source of uncertainty. The president’s desire for a positive economic backdrop for the campaign makes an easing of the trade war with China very likely, although we do not expect a substantive long-term agreement. Trade tensions are likely to persist given geopolitical considerations make this a bipartisan issue in Washington.
The race for the Democratic nomination is likely to produce further surprises. Even if Elizabeth Warren, a more radical choice, wins the nomination and is elected, she would likely face a divided Congress and would not be able to implement highly controversial policies such as Medicare for all. However, tighter regulation of finance and big tech remain possible.
In terms of sectors, we anticipate a rebound for manufacturing from this year’s trough in the inventory cycle – the third since the financial crisis – and the potential for a rerating of healthcare as it becomes clear Medicare for all is off the table. We also see potential gains in big tech after large investment at Facebook and Google roll off.