Donald Trump revived animal spirits when he was elected POTUS on November 8, 2016. It was an upset victory, for sure. It wasn’t widely expected, and it certainly upset Hillary Clinton and other Democrats, who now refer to themselves as “The Resistance.” Nevertheless, the animal spirits remain elevated.
The S&P 500 rallied dramatically, gaining 34.3%, after Trump’s election through 2017 and until it peaked at a record 2872.87 on January 26 of this year (Fig. 1). It is down 5.1% since then through Monday’s close. The rally was driven by Trump’s championing and implementing deregulation. It was also driven by expectations of tax cuts, which were enacted late last year. The S&P 500 has been zigzagging below its record high as a result of Trump’s protectionist saber-rattling since January 22, when he imposed tariffs on imports of solar panels and washing machines (Fig. 2).
Yet despite the rising risks of a full-blown trade war, animal spirits remain animated in the US. The US economy is performing well, and the stock market has been holding up remarkably well despite mounting protectionist tensions between the US and our major trading partners. Indeed, the S&P 600 SmallCaps has been mostly zagging to new record highs (Fig. 3).
Presumably, SmallCaps are less exposed to the risks of protectionism than LargeCaps. On the other hand, we previously noted that within the S&P 500, cyclical stocks have been outperforming defensive ones since Trump’s election (Fig. 4). That runs counter to the greater exposure of the former than the latter to protectionism. It is more consistent with the backup in bond yields since Trump won on expectations that his policies would be stimulative, forcing the Fed to raise interest rates aggressively rather than gradually. Let’s review the state of animal spirits:
(1) GDPNow forecast remains strong. The Atlanta Fed’s GDPNow tracking model lowered the Q2 estimate below 4.0% after personal income was reported last week. It was back up to 4.1% after yesterday’s release of construction spending during May and June’s ISM survey of manufacturing purchasing managers.
(2) Purchasing managers remain in high spirits. June’s M-PMI remained at an elevated level of 60.2, as Debbie discusses below. The new orders (63.5), production (62.3), and employment (56.0) components were also relatively high last month (Fig. 5). This augurs well for S&P 500 revenues growth on a y/y basis, which is highly correlated with the M-PMI (Fig. 6).
(3) Urge to merge remains strong. Joe and I have noted that corporations used some of their repatriated earnings to buy back their shares at a record pace during Q1. That has provided support to stocks at a time when they were pressured by Trump’s protectionism, which somewhat dispirited investors in equity ETFs (Fig. 7).
Also providing support to the market is the rapid pace of M&A activity. According to Dealogic, it totaled $532 billion during Q2 and $1.74 trillion over the past four quarters (Fig. 8).
(4) Joe wants us to raise our earnings forecast. Joe and I benchmark our S&P 500 earnings-per-share forecasts to the consensus estimates of industry analysts covering the companies in this composite. We do so recognizing that the analysts tend to be too optimistic. So our estimates tend to fall below their consensus.
However, Joe alerts me that our 2018 and 2019 estimates ($155 and $166) may be too low relative to the analysts’ highly spirited current estimates ($161 and $177) (Fig. 9). I agree. So we are now projecting $158 for this year and $169 for next year. Of course, that comes with the usual hedge clause these days, namely “barring a trade war.” (See YRI S&P 500 Earnings Forecast.)
The Fed: Cool Hands Powell. Last week, we learned that the Fed finally had hit its 2.0% inflation target dead-on after nearly a decade of highly accommodative monetary policy. Melissa and I doubt that the Fed’s bullseye will change Fed Chairman Jerome Powell’s approach to monetary policy. Since Powell began his tenure as Fed chair on February 5, he has expressed a balanced view of the US economy. Powell consistently has stressed that the Fed will continue to tighten monetary policy at a gradual pace.
The even-handed Powell once again presented his two-handed view at an ECB forum on Central Banking in a 6/20 speech titled “Monetary Policy at a Time of Uncertainty and Tight Labor Markets.” Powell concluded: “Today, with the economy strong and risks to the outlook balanced, the case for continued gradual increases in the federal funds rate remains strong and broadly supported among FOMC participants.” Here are a few more of the key points from his speech:
(1) Jobs: Good, but not as good as it gets. On one hand, Powell began with a positive note about jobs: “Today, most Americans who want jobs can find them. … A tight labor market may also lead businesses to invest more in technology and training, which should support productivity growth.” He added: “In short, there is a lot to like about low unemployment.”
On the other hand, Powell expects the job market to “strengthen further.” He stated: “The labor force participation rate of prime-age workers has moved up in recent years but remains below pre-crisis levels. In addition, wage growth has been moderate, consistent with low productivity growth but also an indication that the labor market is not excessively tight.”
Traditionally, the Fed has relied on the Phillips curve, or the inverse relationship between inflation and unemployment, to guide policy decisions. Powell repeatedly has suggested that he questions the strength of the relationship. In his speech, he stated that “a flatter Phillips curve makes it harder to assess whether movements in inflation reflect the cyclical position of the economy or other influences.” The subdued pace of wage growth despite incredibly low unemployment seems to be the key reason that Powell won’t likely be quick to change his view on the Fed’s future course of action.
(2) Financial stability: Fine, but warrants watching. On the topic of credit bubbles, as we discussed in the section below, investors may find it comforting that Powell does “not see broad signs of excessive borrowing or leverage.” He further stated that “banks have far greater levels of capital and liquidity than before the crisis.” Powell sees US financial stability vulnerabilities as moderate. Nevertheless, he said that “the fact that the two most recent US recessions stemmed principally from financial imbalances, not high inflation, highlights the importance of closely monitoring financial conditions.”
(3) Growth: Strong, but could be stronger. Powell’s perspective of US economic growth also has two hands. On one hand, Powell said: “Growth is meaningfully above most estimates of its long-term trend.” On the other hand, he qualified that with: “the trend is not as strong as we would like it to be.”
Credit: Big Corporate Debt Bubble? Corporate debt levels have surged to record highs. That has led to all sorts of dire warnings from the media about a credit bubble, as we discussed in our 6/19 Morning Briefing. Corporations have had a huge incentive to take on more debt: It has been incredibly inexpensive to borrow for nearly a decade now. The worry is that all that debt could lead to another crisis, especially as interest rates rise, increasing the cost of refinancing maturing debt.
When corporate liquid assets are subtracted from corporate debt, the talk of a credit bubble seems less credible. However, corporations with a lot of cash could distort the net debt statistic on a macro basis. Recent data confirm this distortion for the wide universe of nonfinancial corporations (NFCs). However, larger firms included in the narrower S&P 500 universe seem to have a healthy distribution of cash relative to their debt loads.
Investors in the S&P 500 can take some solace in this. But they should keep watch for signs of trouble among the larger universe of smaller companies, which could spill over into the broader economy. Nevertheless, as discussed below, default rates for NFC borrowings are expected to remain low, at least for the near term. Let’s start with the sobering news before turning to the uplifting news:
(1) Lots of cash & debt. According to a 6/26 report by S&P Global, total debt outstanding rose to $6.3 trillion in 2017 for the roughly 1,900 NFC borrowers rated by the agency. Total debt has risen roughly $2.7 trillion over the past five years. Cash as a percentage of debt is at 33% for US corporates overall, which is flat with the 2016 level. These companies reported holding $2.1 trillion in liquid investments as of year-end 2017. That’s “an increase of 9% versus 2016 and more than double the cash balances reported in 2009.”
(2) Sobering data. “Removing the top 25 cash holders from the equation paints a more sobering picture,” the report observed. “Speculative-grade borrowers, for example, reached a new record-low cash-to-debt ratio of just 12% in 2017, lower than the 13% reported in 2016 and even below the 14% reported in 2008 during the Great Recession.”
S&P Global sees a similar trend among highly rated borrowers: “More than 450 investment-grade companies that aren't among the top 1% have cash-to-debt ratios more similar to those of speculative-grade issuers than to those in the top 1%. Their collective cash-to-debt ratio now stands near 21%.” That’s “a slight improvement from 20% reported a year ago but is still very low when compared to the past decade and is only modestly better than the figures reported just before the recession starting in 2008.”
(3) Bigger is better. On the other hand, the cash position for the top 1% as a group improved by $150 billion to nearly $1.2 trillion in 2017, according to S&P Global. “Their cash-to-debt ratio remains extremely high at 108%, or more than 5x better than that of the remaining investment-grade issuers.” However, that was a significant decrease from 150% reported last year “as the top 1% continued to borrow as a form of synthetic cash repatriation, as well as [the] inclusion of new companies into the top 25 universe.” Cash flow for the top 1% “remains healthy” and “could support significant shareholder returns.”
(4) Slicing & dicing the S&P 500. MarketWatch reviewed an interesting analysis from Jefferies in a 5/11 article titled: “Why a record $4 trillion in corporate debt isn’t scary.” To understand why, have a look at the chart from Jefferies included in the article. It shows the distribution of net debt to EBITDA ratios among the S&P 500 companies excluding financials. The bottom line is that the bulk of S&P 500 companies have net debt to EBITDA that is well below 6. The “ratio is commonly used by credit-rating firms to see if a company is likely to default on its debt and usually anything above 5 is considered too high, though the ratio varies between industries,” explained the article.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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