“Uncertainty is the only certainty there is.”
The title quote is from mathematics superstar, John Allen Paulos. This quote, coming from someone in a field as seemingly defined as math indicates the variability of life. At BTC Capital Management, we do not start with a premise of, “This is how markets should behave.” Instead, we consider potential outcomes based on a combination of looking at the market’s reaction to past events and projections of future market growth.
This year, we have seen more uncertainty than expected. There isn’t a yearly index of uncertainty we look at. There is, however, a higher degree of uncertainty as to the impact of geopolitical events on the market.
Earnings growth for the second quarter of 2019 was better than expected. The MSCI USA Index, an index that tracks large and mid-sized public U.S. companies, beat analyst earnings expectations by 4.3%. Even though earnings growth decelerated in the quarter by 0.7% year-over-year (YOY), the slowdown in growth was less than expected. Revenues also surprised positively by 0.5%, but with growth of 4.0% YOY. The cause of the divergence of earnings and revenue growth is margin compression. Earnings before interest and taxes (EBIT) margin for the year is expected to contract to 15.9. Compared to last year’s EBIT margin of 16.3. Why? Primarily because companies are paying more for production inputs and are not fully passing on the costs to customers.
Increasing costs in manufacturing and production are also expected in the third quarter data. Earnings growth is expected to decline by 4.0% YOY, but sales are expected to increase by 2.7% YOY. Analysts have been reserved with their earnings estimates this year. They tend to lean toward conservatism when there is increased uncertainty on possible outcomes.
The single greatest factor contributing to this uncertainty is trade disputes. We have seen spikes in market volatility whenever President Trump mentions trade talks. When the mention is positive, markets trade up. When the mention is less positive, markets trade down. This uncertainty in the resolution of trade disputes has led to a wider than normal range of market outcomes. Even though there has recently been higher volatility, the market is doing its best to absorb the hits. The MSCI USA Index is up 20.74% for the year. Returns for the third quarter were modestly positive at 1.56%. If returns stay flat for the year and end at 20%, this will be the second-best year of calendar returns in five years. International market returns are also positive for the year. The MSCI All Country World Index USA returned 14.23% in the first three quarters of the year.
Valuations are close to five-year averages. The MSCI USA Index ended the quarter with a trailing 12-month price earnings ratio (P/E) of 19.2x and a forward 12-month P/E of 17.1x. The five-year averages are 18.9x and 16.8x respectively. We have not seen a large increase in P/E ratios despite the strong year to date return number. This is due to the one-year return number being at only 4.1%. The market decline last December put a lid on potential overvaluation. The reasonable valuation numbers coupled with positive U.S. macroeconomic data leads us to believe a significant market decline is not imminent.
Stay the course
We continue to be upbeat on U.S. equity markets, and see more opportunity from equity markets relative to other asset classes. The expectation is for U.S. company earnings growth to turn positive in the fourth quarter and to remain positive throughout 2020. A resolution of trade disputes has the potential to accelerate returns in equity markets. The low interest rate environment will also contribute to the potential for positive equity returns.
Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet.
The information provided has been obtained from sources deemed reliable, but BTC Capital Management and its affiliates cannot guarantee accuracy. Past performance is not a guarantee of future returns. Performance over periods exceeding 12 months has been annualized.
The information within this document is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Statements in this report are based on the views of BTC Capital Management and on information available at the time this report was prepared. Rates are subject to change based on market and/or other conditions without notice. This commentary contains no investment recommendations and you should not interpret the statement in this report as investment, tax, legal, and/or financial planning advice. All investments involved risk, including the possible loss of principal. Investments are not FDIC insured and may lose value.