About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
Context is everything. Viewing the market through the 4 lenses of earnings, liquidity conditions, valuation, and sentiment, I saw the stock market's −20% mini-bear in late 2018 as a buyable correction: sentiment extreme + Fed pivot + no recession = buying opportunity, in my book. And I remain reasonably constructive on equities despite the 18% rally since Boxing Day.
That investors continue to sell equities at a rate of $113 billion per year has certainly helped me stay constructive. Everyone just hates this bull market, or so it seems. To me, the December bottom was a sentiment extreme if ever there was one.
But with the market rebounding strongly despite an ongoing erosion in earnings estimates for 2019, the only way for me to be able to justify current valuations is for this earnings dip to be temporary and not the start of an actual earnings recession. I, for one, see 3 reasons for optimism: earnings, the US Federal Reserve, and China.
Earnings estimates for 2019 have fallen like a stone in recent months, to the tune of about .40 percentage points per week. Three months ago the expected growth rate for 2019 stood at 11.9%; last week it was 5.3%.
Downward drift is a normal feature for earnings estimates, of course. In my experience, estimates start too high and then erode as we get closer to the reporting quarter (or year). The low comes right at the beginning of earnings season, and then the bounce happens as companies miraculously beat their lowered estimates. It's the oldest game in town. But for 2019 so far, the slide has been steeper than usual.
This led me to the view that while the December low was buyable, the market wasn't going to be able to make much more upside progress from here, and certainly not to new all-time highs. For that to happen we would need better clarity on the earnings front. If estimates can stabilize in the mid-single-digit range and rebound to trend (6% to 7%) in 2020, then I think all should be well.
This is what Wall Street seems to be betting on. The estimates for the next 5 quarters are −2.9% (Q1), +1.5% (Q2), +2.7% (Q3), +9.4% (Q4), and +15.2% in Q1 2020. In other words, we will see a single-quarter contraction followed by a V-shaped earnings recovery, basically to match the V-shaped price recovery for the S&P 500®.
But we just finished February, so who knows how much further the estimates will drop? Maybe the consensus is wrong and we get the earnings recession that some seem to expect. If so, this market is overvalued at a price-earnings ratio of 16.4x next year's earnings.
So, I noted with interest that, for the second week in a row, the 2019 growth estimate fell by only 0.03 percentage points. This is less than 1/10 the weekly drift that we have seen over the past 17 weeks. It's way too soon to start making conclusions on whether the bleed is finally ending (or at least moderating), but if so, I believe it could lead to a more bullish shift in the market's narrative, from "imminent earnings recession" to "the worst is behind us." If that's the case, the sellers of that $113 billion in equities may need to reconsider, and that could provide fresh fuel for a market that all of a sudden has a better story line.
Two other developments could help shift the narrative. One is the possibility that the Federal Reserve is going to adjust its inflation mandate from targeting an inflation rate of 2% to so-called price-level targeting. Rather than targeting a 2% rate of change, the Fed will allow inflation to overshoot in order to make up for all the time that inflation has spent below 2%. Given how long inflation has been undershooting 2% (years and years), this could in theory lead to a prolonged period of relative dovishness.
I'm skeptical that this change in approach will actually create more inflation, but it could tilt the narrative toward one where the market worries less about the Fed taking the punch bowl away and the curve inverting, and starts viewing this change as a cycle extender: a reboot of sorts, like early 2016.
The third development relates to China. For months I have been waiting for the typical 2-year reflation cycle to kick in, to no avail—at least until now (potentially). According to Bloomberg, January showed a big jump in aggregate financing (formally known as "total social financing"), to the tune of CNY 4.6 trillion ($690 billion). So now I am wondering whether China's anticipated reflation has finally arrived. If so, that could change the narrative for global earnings growth and emerging markets' relative performance.
As for emerging markets (EM), the middle panel of the chart below shows that China's credit impulse more or less leads EM's relative earnings growth (relative to the US, that is). It's far from a perfect fit, but it sort of makes sense conceptually. If the credit impulse is turning here, then EM earnings could outperform US earnings, which suggests that EM equities could outperform US equities.
Speaking of EM earnings, it looks to me like the 2019 earnings progression is bottoming. If that's the case, I think it adds further support to the idea that EM can outperform the US for a while.