By Thomas A. Martin, CFA, Senior Portfolio Manager – GLOBALT Investments.
Remember what it looked like last time? That turned out to be the third quarter of 2018. S&P 500 year/year EPS growth re-accelerated from just above zero in 2016 to +11% area in 2017, and then again in the first three quarters of 2018 to the +25% area. The pattern was similar for GDP, which rose from +1.7% growth in 2016 to
+2.3% in 2017 and then to +3.0% in 2018. The S&P 500 climbed steadily to a new high in January of 2018, hiccupped -10% until March, then drove to a new high in late September.
Earnings reports for the third quarter of 2018 came in strong, but the markets seemed to be increasingly concerned about a deceleration in the fourth quarter. They wavered until December, when the Fed made its first “policy mistake” (raising rates and saying more was to come), which kicked markets into their December swoon. Earnings growth decelerated in the fourth quarter of 2018 and then fizzled out in 2019, with quarterly year/year growth hovering in the zero percent area for the next four quarters; and producing a rocking +1.0% for the full year. GDP growth decelerated as well to below +3.0%, but managed to stay above +1.5%.
The markets, however, were undeterred. But not because of anything to do with earnings growth. The Fed, in perhaps its fastest policy reversal, said they were sorry, reversed their policy mistake, said it wouldn’t happen again. Now, after there is even talk about tapering bond purchases, the Fed publishes a rainbow in the next edition of its minutes.
The markets forgave and powered on to several new highs in the back half 2019. As turbulent as things were (think tariffs and China, etc.), GDP growth hung in and EPS growth looked like it had a shot at re-accelerating again. Volatility was low, and in January of 2020, sentiment was elevated, optimism was back, and complacency was lackadaisically considered to be a risk. We know what happened next.
Worldwide pandemic, mega uncertainty, and a scramble to right the ship. Everything economic went into a tailspin as people’s lives were abruptly altered, un-evenly and often tragically. Many parts of the economy had a disconnect, and GDP growth and corporate earnings growth set new records for declines. The markets seemed to immediately discount this disconnect, but it didn’t last long. The S&P 500 was back to a new high before summer was over. And why not? Massive monetary and fiscal stimulus was approved and implemented in record time. A vaccine was created and distributed in record time. And a re-opening is happening in a little over a year.
Back to 2019 levels and then what? In the U.S., GDP and aggregate EPS levels will be back over the 2019 levels this year. After a down -3.5% 2020 GDP year, the median estimate is for +6.4% in 2021, and +4.0% in 2022, before moderating back to +2.2% in 2023 and then back to the “old normal” levels of +1.9% in 2024 and 2025. For the S&P 500, after a down -13.9% EPS year in 2020, analysts are expecting +33.8% growth in 2021, followed by +11.8% growth in 2022 and +8.4% growth in 2023. But the peak in growth, the peak, is potentially already upon us, according to these estimates. Second quarter they say. And we just got out of the red. To answer the question posed, we believe the peak in growth this time looks fast on the way up, and potentially slower on the way down, generally the opposite of the last time. There are a lot of other things that are different too.
What is the set up going into the growth peak? Still very high unemployment and low participation, so potential for improvement here. The offset is the still unknown changes to the economy, not least of which is the ongoing fear of a contagious disease. Other issues include work, play, learn from home, changes in consumption and demand patterns, changes in goods and services capacity, jobs skills mismatches, supply chain disruptions, shortages price/inflation disruptions and their duration, and uneven recovery throughout the world geographically and socio-economically.
Massive monetary stimulus remains in place the world over. The appetite for removing that and making a policy mistake is small, both from the standpoint of those who make the policy and those who receive it. The fiscal stimulus that has been enacted has a good bit more to go, even as some is being withdrawn. Additions are still very much being discussed.
The broad equity markets remain near all-time highs, risk aversion is near lows, and valuations are still dear.
How will the markets react to the coming deceleration in growth? Get ready for the “soft landing” discussion to make its way back to the top of the word searches. It is not so much about what the growth is now, but what it is expected to be and, more importantly, what its drivers are and what the macro lay of the land is. Strong consumer? Investment in people and capital? Productivity increases? Low rates? Inflation under control? Central banks not tapering or raising rates? We believe things will probably be OK. Something goes wrong here, maybe not so much. Throw in a set of tax increases that the markets deem growth un-friendly and there may be digestive problems, as this is not perceived to be currently “priced in.” Soft landings do happen, but oftentimes they don’t, and the reasons, excluding policy mistakes, have a way of surprising. At GLOBALT, we believe this set-up still supports cautious positioning in investment portfolios.
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