Key Private Bank’s 3rd Quarter Market Outlook
After starting the year a bit sluggishly, the US economy is currently displaying signs of accelerating growth, both relative to its recent trend and also against its international peers. Consequently, US stocks are outperforming international issues, but stocks as a whole continued to outperform bonds in 2018 through the third quarter.
In our mid-year update and outlook publication, we stated: “As we look ahead to the balance of the year and beyond, our view might best be summarized as more cautious than optimistic. To be clear, full-blown pessimists we are not, but risks are rising in our view, and as such, investors should be preparing for lower returns, higher volatility, and continued uncertainty relative to the recent past.”
With the benefit of hindsight, we can say that our cautiousness was not rewarded, as stocks gained 7.71% in the third quarter. Nonetheless, we continue to believe that prudence is warranted, and we encourage investors to expand their definition of diversification and explore uncorrelated return streams to the extent they are able to do so.
And above all else, we believe in remaining disciplined and focusing on one’s long-term objectives. These are things we can and should control, and these are the determinants of long-term investment success.
3rd Quarter Review – US Equities
Despite the headlines focused on rising trade tensions, the Federal Reserve (Fed) hiking interest rates, and tumultuous Senate hearings, the S&P 500 index climbed the proverbial “wall of worry” and gained more than 7% in the third quarter. That was its best quarterly performance since the fourth quarter of 2013. With the S&P 500 ending the quarter near its all-time high, it would only be natural to assume that investor giddiness has bid up stocks to expensive valuations. But that’s simply not the case. As Figure 1 shows, the trailing price-to-earnings ratio (P/E) on the S&P 500 is 19.5x, which is well below its average P/E of 20.5x from 2015 through 2017.
The primary driver of the S&P 500’s year-to-date return of 10.6% is strong earnings growth. According to Bloomberg, the S&P 500’s earnings per share grew 19.7% in the first quarter and 24% in the second quarter.
The consensus estimates for the third and fourth quarters are +25.6% and +27.1%, respectively. If those earnings per share (EPS) estimates are met, the S&P 500 will deliver earnings growth of 23.5% in full-year 2018.
That impressive earnings growth is a step-function higher than the S&P 500’s EPS growth in 2017, which was 10%. While the solid economic backdrop and the Fed’s interest rate policy play an important role, it is the corporate tax cut that was passed at the end of 2017 that is having the biggest impact on earnings growth in 2018.
Looking Ahead to Q4 – US Equities
While we expect the economy to remain on solid footing, the Fed to maintain its measured pace of rate hikes, and further benefits from lower corporate tax rates – we also expect the upside for equities to be limited during the upcoming third-quarter earnings season.
In the first half of 2018, S&P 500 companies topped quarterly estimates at an above average rate. In the first quarter, 79% of companies surpassed EPS estimates, and 81% beat EPS expectations in the second quarter. For the third quarter, we believe EPS reports will be more subdued relative to current expectations. We base this view on company guidance given during second quarter conference calls.
A line graph titled, “S&P 500 Trailing Operating P/E: 2018 has been a year of multiple contraction” appears on the page, displaying the S&P 500’s Trailing Operating Price to Earnings ratio from 2010 through 2018. The X-Axis of the graph lists years in sequential order starting with 2010 with a single listing for each year running up through 2019. The Y-Axis lists P/E ratio levels starting at 10, running in increments of 2 up through 24.
The line graph begins at the 2010 listing, which reports a value of 17.68x. The line graph then dips significantly with volatility to 13.78x by Q3 2010, before increasing with volatility to 15.16x by January 2011. The line elevates slightly to a value of 15.24x before experiencing a notable drop in value to a level of 11.95x by approximately the 3rd quarter mark of 2011, marking a low point on the graph. The graph then increases with volatility to a value of 13.53x by the start of 2012, increasing again with significant volatility to 15.39 by the beginning of 2013. From here, the line experiences a slow increase with notable volatility, marking points of 16.53 at the beginning of 2014, 17.73 at the 2015 marker, and 19.47x by the 2016 marker. At this point, the line marks a sharper increase with minor volatility reaching a point of 21.89x at approximately the midway point of 2016. This was then followed by a decrease in ratios down to 21.12x by the beginning of 2017. Throughout 2017, price-to-earnings ratios remained volatile, before increasing to a ratio level of 22.22 at the start of 2018, which marks a high point on the graph. The graph then marks a sharp decrease in price-to-earnings ratio, falling with minor volatility to a level of 19.54 at approximately the 3rd quarter marker in 2018.
Specifically, the percentage of companies issuing positive EPS guidance (EPS guidance above consensus estimates) fell dramatically for the third quarter. Only 20% of S&P 500 companies issued positive EPS guidance for the third quarter. While that is in-line with the average of 27% in the 10 quarters prior to 2018, it is down from 48% in the first quarter and 39% in the second quarter.
The optimistic corporate guidance in the first two quarters of this year reflected the positive impact from federal tax reform, but it took a few quarters for analyst estimates to finally incorporate the benefits of tax reform. S&P 500 earnings should grow around 25% in the third quarter, but fewer companies will beat expectations. As a result, we expect US equities to continue to march higher through year-end, but caution that upside from third-quarter earnings reports is likely to be subdued.
A bar graph then appears on the page, which is titled, “S&P 500: Percentage of Companies Issuing Positive EPS Guidance”. This graph outlines the percentage of S&P 500 companies issuing positive earnings per share (EPS) guidance over time. The X-axis consists of quarterly measurement periods with each listing signifying a quarter. The quarterly measurement listings begin at 3rd Quarter in 2015, listing every quarterly running up through 3rd Quarter 2018. The Y-axis consists of the total percentage of companies issuing positive EPS guidance for each of one of these quarters, beginning at 0%, running in 10% increments up to 60% at the top for the graph. Red bars span at across the graph at each quarter listing to note the positive EPS guidance issued per quarter.
The 3rd quarter 2015 listing reported at 26% of companies that are part of the S&P 500 issuing positive EPS guidance. During the 4th quarter of 2015, the red bar listing dropped slightly to 22%. At the 1st quarter mark in 2016, the red bar dropped again, this time decreasing by 7%, leaving only 15% of companies reporting positive EPS guidance which is the lowest mark on this graph. The 2nd quarter in 2016 brought a dramatic increase of 14%, bringing the total to 29% of companies. For 3rd and 4th quarter in 2016, this rate then decreased slightly both months, measuring in at 27% and 26% respectively. The 1st quarter 2017 listing on the graph also decreased, showing 23% of companies issuing positive EPS guidance. The graph then sees two significant increases with 29% and 36% listings in the 2nd and 3rd quarters of 2017. 4th quarter of 2017 then saw a decrease, with the bar lowering to 33%. 1st quarter of 2018 then saw a dramatic increase, spiking to a total of 48% of companies in the S&P 500 issuing positive EPS guidance—a high point on the graph. 2nd quarter and 3rd quarter then saw significant decreases with a 39% rate in the 2nd quarter of 2018, and a 20% rate in 3rd quarter of 2018.
Fixed Income Overview
The Federal Open Market Committee (FOMC) continued to normalize interest rates during the third quarter by raising short-term rates by 25 basis points at its September meeting to the range of 2.00% – 2.25%. Meanwhile, investors have been focusing on the path of rate hikes and the trade war.
Trade war rhetoric continues to intensify and uncertainty as to the resolution of discussions remains, increasing volatility across the US Treasury market. While the US, Canada, and Mexico appear to have negotiated a deal, the US and China remain far apart.
As China and the US continue to add tariffs to each other’s goods, the impact is being felt in China. China’s official manufacturing purchasing managers’ index (PMI) fell a half point during the month of September to a reading of 50.8 – weaker than the consensus estimate of 51.2. Tensions between the US and China are likely to rise in the coming months, which could lead to added uncertainty over interest rates.
Treasury yields were higher across the board during the third quarter, with the 2-year note yield rising 29 basis points to 2.82% and the 10-year note yield rising 20 basis points to 3.06%. The yield curve continued to flatten (2-year note yield rising faster than 10-year note yield) as the rate normalization process by the FOMC continued.
While China has yet to do so, as one of the largest holders of US Treasuries at just under $1.2 trillion, should they begin selling its holdings, rates in the US could rise faster than expected as added supply hits the market.
Returns across the fixed income asset class were muted during the quarter as the Bloomberg Barclays Aggregate Index, a broad measure of the US bond market, returned just 0.02% during the quarter bringing, the year-to-date return to -1.60%. Long-dated US Treasuries were the worst performing fixed income asset class in the US, falling 2.88% during the quarter (-5.79% year-to-date), while high yield was the best performing fixed income asset class during the quarter, returning 2.40% (2.57% year-to-date).
2018 and Beyond
As the FOMC continues to normalize rates, one additional rate hike for 2018 and three rate hikes for 2019 are expected. The FOMC will keep a close eye on inflation, which has remained in check so far. While wage inflation has remained subdued, with the unemployment rate at 3.9% we believe the risk of higher wage inflation is elevated.
We believe volatility is likely to rise across the Treasury market as trade war tensions with China increase. We estimate Treasury yields will continue to gradually rise in the next 12–18 months, with the 10-year note yield ending 2018 around 3.00% and rising to 3.50% by year-end 2019. With the increased trade tensions, corporate bonds will likely see increased volatility as well. While we remain overweight corporate credit, we prefer the front end of the credit curve (maturities of three years and less) versus longer maturities, as the flatness of the yield curve makes it attractive on a duration adjusted basis. We expect the fixed income markets to remain challenging for the remainder of 2018, as well as 2019.
A bar graph then appears next on the page with the title “FOMC Probability of One Rate Hike”, showing estimated probability percentages for rate increases based upon FOMC meetings. Three bars are located at each X-Axis listing, with a red bar signifying percentage probability based upon the FOMC Meeting on July 31, 2018, a grey bar noting percentage probability based on the August 31, 2018 FOMC Meeting, and a black bar representing percentage probability based on the FOMC Meeting on September 28, 2018. The X-Axis notes three upcoming FOMC meeting dates on November 8, 2018, December 19, 2018, and January 30, 2019 respectively. The Y-Axis of the graph lists the percentage probability of rate hikes in 20% increments starting at 0%.
The first listing on the bar graph, furthest to the left, signifies the estimated probability of a rate hike on the upcoming FOMC Meeting on November 8, 2018. Based upon the July 31 meeting data, the red bar notes an 83% chance of a rate hike, whereas the August 31 meeting bar in grey notes a 94.6% chance of a rate hike. The black bar representing September 28, 2018 meeting data notes a dramatic difference from the other two bars, placing the possibility of a rate hike at 2.7%.
The second X-axis listing shows the forecasted chance of a rate hike at the upcoming FOMC meeting on December 19, 2018. The July 31, 2018 meeting data bar first notes a 96.1% possibility of a rate hike, with the August 31 meeting data bar showing 98.2% chance, and the September 28, 2018 meeting data bar notating a 71.3% chance of a rate hike.
The third and final X-axis listing provides a forecast for a potential rate hike based upon the upcoming January 30, 2019 FOMC Meeting. For this listing, the red bar representing estimates based on the July 31, 2018 meeting data provides a 96.3% probability, while the grey bar representing August 31’s meeting lists a 98.3% chance of a rate hike, and the black bar noting September 28, 2018’s meeting data anticipates a 72.4% chance of a rate increase.
Another bar graph appears on the page titled, “Probability of 4 Rate Hikes in 2018”, which lists the percentage probability of four rate hikes occurring by the FOMC Meeting dates listed throughout 2018 that have already occurred, as well as the forecasted percentages for three upcoming meetings up through the January 30, 2019 meeting. The X-axis of the graph lists FOMC Meeting dates in chronological order, beginning with the March 21, 2018 meeting, running up through the upcoming FOMC meeting scheduled for January 30, 2019. The Y-axis of the graph lists percentage probability rates beginning with 0%, running in 5% increments up to 30% at the end of the Y-axis. Each listing includes three bars. The red bar signifies percentage probability of four rate hikes occurring based upon December 31, 2017 data, whereas a black bar represents probability of four rate hikes based on January 31, 2018 FOMC meeting data, and finally a grey bar which notates probability percentages for four rate hikes driven by FOMC data from the March 12, 2018 meeting.
The first two listings on the X-axis are for the ¬¬March 21, 2018 and May 2, 2018 meetings. For both listings, no bars are visible on the graph, signifying a 0% chance of four rate hikes occurring by the meeting based upon FOMC meeting data from all three evaluated dates.
The third listing from the left on the X-axis, represents the FOMC meeting on June 13, 2018. The red bar representing percentage probability of four rate hikes based upon the December 31, 2017 meeting data indicates a 0.4% chance, whereas the black bar notes a 0.3% chance of four rate hikes, and the grey bar representing percentage probability of four rate hikes based upon the March 12, 2018 meeting data indicating a 0.5% chance.
The fourth listing on the X-axis is for the percentage probability of four rate hikes at the August 1, 2018 FOMC meeting. The red December 31, 2017 meeting data bar reports a 1.1% probability of four rate hikes in 2018, with the black January 31, 2018 bar indicating a 1.6% probability, and the grey March 12, 2018 meeting data bar noting a 1.9% chance of four rate hikes occurring.
The fifth listing on the X-axis of the graph is for the September 26, 2018 FOMC meeting. The December 31, 2017 meeting data bar reports a 4.6% possibility of four rate hikes, with the January 31, 2018 bar showing a 9% chance, and the March 12, 2018 bar displaying a 11.6% possibility of four rate hikes occurring.
For the sixth listing, reporting forecasted probability rates of rate hikes at the November 8, 2018 meeting, rates continue to rise significantly. The red bar representing the December 31, 2017 FOMC meeting data indicates a 5.4% chance. The black January 31, 2018 bar reports a 12.7% chance of four rate increases. Finally, the grey March 12, 2018 bar displays a forecasted 16.5% rate.
The seventh and penultimate listing on the X-axis reports probability of four rate hikes by the December 19, 2018 meeting. The red December 31, 2017 FOMC meeting data bar reports a forecasted 9.9% rate, with the black January 31, 2018 data bar listing a forecasted 20.6% rate, and the grey March 12, 2018 bar reporting a forecasted rate of 25.3%.
The eighth and final listing on this bar graph reports probability rates for four rate hikes to occur by the January 30, 2019 meeting date. The red bar representing the December 31, 2017 FOMC meeting data indicates an anticipated 9.9% probability. The black January 31, 2018 bar reports a 21.9% chance of four rate increases. Finally, the grey March 12, 2018 bar displays a forecasted 26.5% probability rate.
Investment Grade Credit
US Investment Grade Credit outperformed the broader market in the third quarter, returning 0.97% versus a return of 0.02% for the Bloomberg Barclays Aggregate Index. Year-to-date, US Investment Grade Credit has underperformed the broader market, returning -2.33% versus -1.60%.
US Investment Grade Credit spreads ended the quarter at 105 basis points, 18 basis points tighter. Spread tightening was led by lower rated ‘Baa’ rated credits, which tightened during the quarter. Single ‘A’ rated credit spreads tightened to 85 basis points, while ‘Aa’ rated credit spreads tightened 15 basis points to 56 basis points.
Higher Treasury yields should help drive demand for Investment Grade as investors begin to find potential returns attractive again. We believe that solid corporate balance sheets and a benign economic environment will continue to be supportive for US Investment Grade credit. We remain overweight US Investment Grade credit and believe the front-end of the credit curve (3 years and less) provides attractive returns versus money market alternatives. A risk to our overweight in corporate credit is a “rush for the exit scenario” caused by increased tension over the trade war.
This next line graph displayed on the page is titled, “Investment Grade and High Yield OAS”, reporting option-adjusted spreads, or OAS, in basis points. The investment grade OAS is signified by a red line, whereas the high yield OAS is represented by a blue line. The X-axis lists year-end and mid-year dates starting December 31, 2015, tracking up through June 30, 2017. The primary Y-axis on the left side of the chart reports Investment grade basis points starting at 0, running up through 2.50 basis points in 0.5-point increments. The secondary Y-axis on the right side of the chart reports High Yield OAS basis points starting at 0, ranging up to 9.0 basis points in one-point increments.
The first listing within the X-axis, furthest to the left on the graph is the year-end 2015 listing of December 31, 2015. The red Investment Grade OAS basis points line reports a 1.65 basis points level, with the blue High Yield OAS basis points line reporting a 6.6 basis points value. Both lines increase in value with volatility, reaching a high point on the graph at the February 2016 mark. From here, both lines decrease again with notable volatility reaching a value of 1.51 basis points for Investment Grade OAS and 6.16 basis points for High Yield OAS by the June 30, 2016 listing on the X-axis. Both lines continue to trend slightly downward over time with volatility, reaching levels of approximately 1.22 basis points for Investment Grade OAS and 3.97 basis points for High Yield OAS respectively. Both lines continue to fluctuate slightly based upon volatility throughout the early 2017 area on the graph but remaining mostly stable and at the same levels. By the mid-year, June 30, 2017 listing on the X-axis of the graph, the red Investment Grade OAS line displays a 1.1 basis point value, whereas the blue High Yield OAS line reports a 3.69 basis point value. The lines continue past this final X-axis listing reporting through the remainder of 2017. These lines continue to fluctuate modestly with volatility and end the reporting period of the graph at levels of 1.05 basis points for Investment Grade OAS and 3.5 basis points for High Yield OAS.