By Salvatore J. Bruno, Chief Investment Officer and Managing Director for IndexIQ
Maybe earnings aren’t so bad after all
Early indications are that the current earnings season might not be quite the disaster that was predicted by some. This is partly a matter of reduced expectations, but also a function of an underlying economy that remains solid, if not robust.
Through mid-October, about 10% of the S&P 500 had reported, including the banks, and earnings were generally coming in above expectations. There was top line growth, too, in many cases. On the back of this (and a positive cycle in the highly volatile trade news) U.S. stocks have been mostly higher.
Trade, of course, continues to loom over the market outlook but here, too, there has been reason for optimism. China and the U.S. appear to be moving towards some kind of interim solution and British Prime Minister Boris Johnson has yet another Brexit agreement on the table, though whether it will be approved is anyone’s guess.
Ten-year and 30-year interest rates have started climbing again and the yield curve has been steepening, a good sign for economic growth. Small cap stocks tend to grow earnings faster than large caps but in this long-running period of uncertainty they have generally underperformed. An acceleration in growth – if it happens – should be good for this asset class. Mortgage REITs, that seek to leverage yield spreads between short- and longer-term mortgage bonds, may also benefit from a steepening yield curve. High yield bonds are another potential beneficiary as continued growth provides the cash flow to service debt.
There have been some short-lived suggestions that cyclical stocks may start to outperform, replacing value and low volatility. It’s still too early to conclude that’s happening but it’s something investors should keep an eye on. If it happens, small caps and high yield bonds won’t be the only beneficiary: commodities should do better as well.
With all the headlines and market disrupting tweets, it’s easy to forget that stocks are ultimately driven by earnings. The projection for 3Q is a drop of -4.1% which would mark the third straight quarter of year-over-year declines. Lower earnings weigh on valuations. The forward 12-month price/earnings ratio for the S&P 500 is around 16.5, according to FactSet. This is below the five-year average of 16.6 but above the 10-year average of 14.8.
But as 3Q earnings roll in, the market will start discounting forward. In the near term, a lot will depend on what investors hear from management in addition to the numbers themselves. Early indications are that there’s good news in the broader economic data to go along with the less good. On the one hand, unemployment is still low and wages are rising; on the other, the September report on retail sales showed a decline and economic bellwethers like UPS have come up short on earnings. The International Monetary Fund recently cut its outlook for 2019 global growth to 3.0%, but it raised the outlook for next year to 3.4%.
There’s clearly been a tug of war going on in the markets for the past 12 months, with those expecting a trade-based recession on one side, and those doubting that outcome and pointing to the strength of the underlying fundamentals on the other. It remains to be seen which side will win, but the proof will eventually be in the earnings.
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Real Estate Investment Trusts or REITs are publicly traded companies involved in property development, management or sales. REITs cover various segments of the real estate market including apartments, hotels, industrial properties, medical facilities, shopping malls and offices. Investments in REITs are subject to the risks associated with the real estate market and mortgage investing. These risks include fluctuating property values, changes in interest rates, property taxes and mortgage-related risks.
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A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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