Are We Out of the Woods?

During the course of my weekend reading, I was struck by the near-unanimous consensus that economic growth is slowing but there is no recession anywhere in sight. Most of the pundits then went on to predict that if indeed the economy stays out of recession, then it is reasonable to conclude that we will also see solid corporate earnings growth and therefore higher stock prices by the end of 2019. Is it that straightforward? After suffering a 20% peak-to-trough correction in stock prices in the fourth quarter, are we now out of the woods?

First let’s look at the current state of the economy. In the first chart below, we show the four-quarter moving average for GDP growth (blue line), along with the contributors to that growth. The blue line clearly shows that economic growth has been accelerating, at least on the basis of the prior four-quarter moving average, since the second quarter of 2016. We don’t have a figure for the fourth quarter of 2018 yet, but the moving average will increase further even if 4Q growth comes in a little below the current estimate of 2.7%. Recent commentary by bank executives on fourth-quarter conference calls provides further evidence of the underlying strength of the economy. Not only did we hear of a late-quarter surge in lending to businesses, but we also learned that credit costs remain remarkably stable at very low levels. This is not the kind of commentary you hear on the eve of a recession.

Just as important as the acceleration in GDP growth are the determinants of that growth. First, consumer spending, represented by the blue bars, has been remarkably consistent for the past several years. Based on a current unemployment rate of 3.9%, continuing job gains, rising incomes, improved access to credit, and the current savings rate, it seems likely that this trend will continue. Second, private investment, represented by the orange bars, has also been a steady contributor to GDP growth. And while fixed investment, both residential and nonresidential, has dropped off in recent quarters, it seems likely that investment will resume now that interest rates have fallen, the Fed is set to pause its rate hikes, and progress has been made on the trade front. Finally, notwithstanding the ongoing partial shutdown, government spending seems likely to continue at high levels based on increases in defense spending, the possibility of an infrastructure bill, and the fact that 2020 is an election year. All these factors add up to continued economic growth, even if not at the rate we saw in 2018.

Source: Bureau of Economic Analysis

How could the domestic economy lose its mojo in 2019? One possibility is that the economic weakness outside the US spreads to our borders. But most of the other possible triggers for economic deceleration would be self-inflected: 1) the Fed continues to hike interest rates into a slowing economy; 2) the Trump administration fails to come to a trade agreement with China; or 3) the federal government stays partially closed for an extended period as a result of the failure to compromise on immigration policy. These potential policy mistakes would eventually affect consumer and business confidence, which would then lead to slower growth in consumer spending and business investment. By and large, though, our leaders, including the Fed, have levers to pull to avoid a recession over the near term, even if those actions are to the detriment of our longer-term economic health (surging deficits and debt, asset bubbles, economic inequality, inflation, labor shortages, etc.).
But investors should be careful not to conflate the economy, corporate earnings and the stock market. In other words, the performance of the stock market is not solely determined by the pace of domestic economic growth; there are several other influences as well. In the chart below, we show that the S&P 500 increased at an annual pace of about 9.4% from the end of 2009 to the end of the 2018 (bar furthest to the right). The first four bars show some of the influences on that 9.4% annualized growth. First, GDP grew by at an inflation-adjusted (or “real”) annualized rate of 2.3% from 2009 to 2018, contributing about 24% of the increase in stock prices (2.3% divided by 9.4%). Next, we can say that inflation, which is the difference between the nominal rate of GDP growth (3.9%) and the real rate of GDP growth (2.3%), averaged about 1.7% from 2009 to 2018. Therefore, inflation contributed about 18% of the increase in stock prices (1.7% divided by 9.4%). Next, we show that revenue for the S&P 500 grew at an annualized rate of about 5.3% from 2008 to 2018. The revenue growth over and above nominal GDP growth contributed about 14% of the increase in stock prices (revenue growth of 5.3% minus nominal GDP growth of 3.9% divided by 9.4%). Next, we show that S&P 500 earnings grew at a much faster pace than revenue (11.3% versus 5.3%) over the time frame. The difference in those growth rates represents the contribution from profit margin expansion to the gains in stock prices, which comes to a huge 64%! The final piece of the puzzle is the change in the multiple of stock prices to earnings, or the “P/E ratio.” The difference between the 11.3% growth rate in earnings and the 9.4% growth rate in stock prices represents the effect that a lower P/E multiple had on stock price growth from 2008 to 2018. Specifically, the P/E multiple decreased from 18.3x at the end of 2009 to 15.6x at the end of 2018. This multiple contraction was a 20% drag on the rate of growth in stock prices from 2008 to 2018.
Sources: FactSet and Bureau of Economic Analysis
Sources: FactSet and Bureau of Economic Analysis
The following is a waterfall chart of the sources of gains in the S&P 500.

Sources: FactSet and Bureau of Economic Analysis

Based on the analysis above, we could be asking the wrong question in forecasting the stock market’s performance in 2019. Maybe the question should not be how fast is the economy going to grow but rather how likely is it that corporate American can grow or even maintain current profit margins? Corporate profit margins benefited for many years from low labor costs, low interest rates, deferred investment, other cost-cutting and restructuring, and now sharply lower tax rates. Now, however, many of those factors are set to be a drag on earnings (once the tax cuts anniversary this year). So if and when the economy stabilizes at the lower growth rate compared to 2018, corporate margins are likely to be the biggest determinant for the future trajectory of the stock market. Client portfolios are positioned defensively, but we believe they should benefit from growth even if it’s a bit more modest.
Source: Bloomberg