Perhaps the biggest question facing investors right now is whether consumer spending will follow the deteriorating trend in the industrial economy that has spread from China to Germany and the U.S. in recent quarters.
For now, the pessimism of stock analysts clashes with the willingness of American consumers to keep boosting corporate profits.
The current economic malaise, while similar in origin to the slowdown that happened in 2015-16, is playing out quite differently.
Then, as now, structural problems in China wreaked havoc among manufacturers. In fact, heavy industry has actually suffered more this time around because of the disruption caused by the U.S.-China tariff spat and tougher emissions regulations in the car industry. The German economy in particular has proven vulnerable.
What is different now is that three years of rising employment and pay seem to have imbued household budgets with a higher degree of resilience. Last week, government statisticians revised down their reading of U.S. economic growth for the second quarter to 2%, due to the impact of weaker-than-expected exports and inventory investment, but recorded a strong pickup in company earnings and consumer spending—now upgraded to its strongest reading since 2014. Official figures also showed a sharp rise in U.S. consumer spending in July.
This has benefited much of the consumer-led economy. During the year’s first half, earnings declined in S&P 500 sectors including industrials, materials and energy, but this was offset by profit growth in consumer industries, health care and even banks. Manufacturing is, after all, only 10% of the U.S. economy.
As a result, S&P 500 earnings per share are up almost 20% relative to the second quarter of 2018. In more export-dependent Europe, Euro Stoxx 50 earnings are down only slightly over the same period. Profits were much weaker in the 2015-16 deceleration, particularly in Europe, where domestically focused industries are also holding up much better.
The disconcerting result has been strong equity returns despite an avalanche of gloomy headlines about the world economy.
One way stock analysts have made sense of the contradiction is with cautious earnings forecasts.
This can be seen in the gap between the profit growth they expect S&P 500 corporations to report in the next 12 months and the profit growth companies have actually reported for the past 12 months. The two metrics tend to be correlated. This year, however, trailing profits in the U.S. have started outpacing profit forecasts by the most since 2011. The opposite was true in 2015 and 2016.
Of course, the gloom will prove justified if the unemployment rate rises and consumers’ pockets get squeezed. Consumer-sentiment data has started weakening and, unlike in 2016, there is the risk that Beijing won’t unleash enough fiscal stimulus to set global demand back on track.
But this scenario would most likely lead to a full-blown recession in the U.S., and analysts don’t seem willing to make that call either—at least not yet. Without a recession on the horizon, it seems unfair to dismiss the S&P 500 (.SPX) as overbought or simply supported by lower bond yields and central-bank policy.
Judging by the resilience of corporate profits so far, equity investors should party like it isn’t 2015.
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