Third quarter earnings have been mediocre. Reported sales growth for the S&P 500 Index as of November 7th was 3.76% while earnings have fallen 1.01%. Certain key sectors such as healthcare and communication services have seen earnings grow nicely, while other key sectors such as information technology and financial services have seen a decline in earnings.
The decline in earnings is the result of slower economic growth in the United States and overseas. There are a variety of reasons for the slowdown but in NPP’s estimation, the global trade war is the biggest factor. Others include last year’s Fed tightening cycle, the resulting stronger dollar and the uncertainty of a UK exit from the European Union. As we assess the outlook, we see reasons to be optimistic that these headwinds may be fading as we enter the new year.
Tariffs, even when justified, rarely if ever produce faster domestic growth. Usually the opposite occurs, and growth slows globally. There are many real, bipartisan trade issues regarding China that will be hard to solve even with a new President or Congress. Several of the main issues are likely to remain intractable for years, if not decades. The strategic interests of the United States and China are opposed on many issues. Nonetheless, we think that the worst of the trade war has passed and that some modest deal will be reached while trade tensions temporarily diminish. The key issues are best dealt with behind closed doors. Neither the United States nor China wins during periods of high tensions and rhetoric and both economies suffer. We suspect two different global technology architectures will emerge: one based on the United States and one on China. As companies become more comfortable with the new rules, capital investment will return even if many supply chains shift and China strategies are reevaluated.
The uncertainty and fear caused by the trade war between the United States and China has delayed investment and contributed to a global manufacturing recession. Manufacturing is a small part of the United States economy and has been less affected. Other countries have been hit much harder by the decline in manufacturing activity. Recently, the intensity of the trade war rhetoric has waned, and the likelihood of a modest deal has risen. A small deal that puts a cap on the maximum amount of pain from trade disagreements would be beneficial for the U.S. and the global economy. 2018 saw a one-time pickup in activity after the tax cuts. Part of the domestic weakness is a bounce-back to normalized levels. As the inventory excesses wane, U.S. activity should increase.
The trade war is not the only source of global uncertainty. Brexit is one notable cause of economic uncertainty. A resolution of Brexit would allow companies to invest in the appropriate locations once the new economic rules are established. Without a resolution, it is hard to justify major capital investment. The likelihood of a “Hard Brexit” has declined and this should be positive on the margin for the economy.
The tightening by the Federal Reserve also played a part in contributing to economic and earnings weakness. Tighter monetary conditions in 2018 via higher interest rates and balance sheet contraction led to slower growth in 2019. Moreover, a flatter yield curve is all else being equal bad for banks and the financial service sector’s earnings. It also leads to higher borrowing costs. The Fed started lowering interest rates and ended balance sheet contraction in the second half of 2019. This stimulus should help the economy in 2020 after hurting it in 2019.
The trade war and the tariffs associated with it contributed to a strong dollar. Additionally, the Federal Reserve was raising interest rates in a low-interest rate world where there is currently $11.9 trillion of global debt with a negative yield according to Bloomberg. While NPP thinks negative interest rates are counterproductive at best, the higher interest rates in the United States contributed to a strong dollar. In turn, the strong dollar led to weaker growth in overseas subsidiaries when foreign profits were translated into dollars. Now, the trade war appears to be peaking while the interest rate differential between the U.S. and developed markets lessens. The ICE Dollar Index has already pulled back a modest 1.52% from its twelve-month high. We suspect the gentle pullback will continue and this would be positive for earnings. NPP thinks global economic growth has bottomed. Despite the lessening of the headwinds, we do not see the double-digit earnings growth that the consensus does. We think five percent earnings growth is more likely, but that should be enough to keep the S&P 500 index moving higher in 2020.