- Emerging markets (EMs) are back in focus, with ﬁnancial turmoil hitting Turkey.
- Unlike 2016, when the US Federal Reserve took pressure off emerging markets by slowing its pace of monetary tightening, this time the Fed may not have that luxury. That means there are likely no quick ﬁxes to EM problems.
- Meanwhile, the US stock market is back near its January highs, but enough potential headwinds are out there to keep the now 6-month-old trading range intact.
- 2019 could prove a pivotal year for US stocks, as I see earnings growth slowing back to trend by then and the Fed getting further and further into restrictive policy.
Investors are watching EMs, with Turkey exploding back into the headlines. The Turkish lira has lost close to 40% of its value from the beginning of the year through August 15.. It's a good reminder that although the US economy remains strong, the same cannot be said across the emerging markets. And unlike what happened in 2016, this time we likely can't count on the US Federal Reserve to open the liquidity spigot and, in turn, dampen the strength of the US dollar. While the S&P 500® is back near its all-time high (reaching 2,863 on August 7, 2018, versus the 2,873 record set in January), the MSCI World ex USA Index is down around 12% since its January 26 peak. And the MSCI Emerging Markets Index is down nearly 20%, within which Turkey was off a whopping 55% (all data as of August 15). Moreover, the Euro Stoxx® Banks Index is down some 26%. European banks always seem to have a front row seat to the happenings in emerging markets. In this case, the Spanish banking system is where the biggest exposures are.
On its own, I don't think Turkey should pose that much of a systemic risk to the US or global markets. Turkey is only a small part of the EM index and it is not a highly indebted country overall. Its debt-to-GDP ratio is a little over 40%, though that ratio is roughly double if one looks just at credit to the non-financial sector versus GDP. However, a fair amount of sovereign and corporate debt is in foreign hands, which is always risky. Therefore, the crisis could develop into contagion if Turkey imposes capital controls to stem the bleeding. This in turn could lead to investors unwinding positions elsewhere. As the old adage goes: If you can't sell what you want, sell what you can. So far this has not happened and it is not the base case. But clearly this is an important line in the sand for Turkey and, more generally, EM equities as an asset class. Keep in mind, though, that the World Bank ranks Turkey as only the 17th largest economy as of 2017, with a GDP less than Apple's current market cap!
Turkey is not the only news, of course. China is another developing story and could indeed prove to be systemic for global markets. The Chinese economy has been doing OK in the grand scheme, but it has been slowing in recent months to the point where the government is now easing fiscal and monetary policy. Indeed, China seems to be following its 2-year "CRIC" cycle1 (crisis > response > improvement > complacency) with good accuracy. The problem with China's slowdown and concurrent policy easing is that it is happening at a time when the US economy is strong and the Fed is tightening. Because China's currency is tied to the US dollar, China is essentially importing US monetary policy. That's fine when the 2 economies are synched up, but not when they are diverging, as is presently the case. The result of all this is that the Chinese yuan has fallen back near its 2015–2016 lows. So far, China's currency depreciation is not as systemic as it was in 2016 (evidenced by the stability of its foreign-currency reserves), but it's something that should be watched.
Trade remains an obvious concern, of course. The risk is that escalating trade tension could lead to "stagflation," resulting in price-earnings (P/E) compression around the world. With the S&P 500® near all-time highs and the Shanghai Stock Exchange Composite Index down about 23% from January 26 to August 15, it's easy to declare winners and losers, but rising tariffs could cause a 1-2 punch for all markets in the form of declining profit margins coupled with rising prices.
If there is one thing we've learned from studying economic history, it's that stagflation equals a headwind for valuations. EM equities continue to track the 2014–2016 analog with close precision, despite the fact that the earnings backdrop in emerging markets is better today than it was a few years ago. The chart below shows the analog across various metrics, and links the 2 periods to the point at which liquidity conditions (as measured by the Goldman Sachs Financial Conditions Index) started to tighten (August 2014 versus January 2018). The last EM rout ended in early 2016 when the US Federal Reserve was forced to dial back its hawkish forward guidance. In effect, the Fed "eased" simply by tightening less than the markets had priced in, proving once again that we live in a "flow" and not a "stock" world (i.e., the rate of change matters more than the absolute level).
That was 2½ years ago, however. Back then, the Fed had the luxury of operating in a regime of secular stagnation (or at least persistently anemic growth) and inflation was well below target, which allowed the Fed to ease off the throttle in terms of its tightening path. The Fed had nothing to lose by not tightening as quickly as it had telegraphed. The impact was the same as a rate cut. The same cannot be said today, however. I don't think we can count on the Fed lowering its guidance to bail out emerging markets anytime soon, in the process bringing down the US dollar and allowing financial conditions to ease. This time around, the secular stagnation era seems like a thing of the past, and we are edging ever closer to the late stages of the business cycle. July's 2.4% core consumer price index (CPI) print was a good reminder of this. The core CPI is calculated by the US Bureau of Labor Statistics and excludes the relatively volatile prices for food and energy.
Without the Fed coming to the rescue, an EM rout likely would have to be resolved the old-fashioned way: through hard medicine. In emerging markets, that generally means central-bank tightening, currency devaluation, recession, and painful fiscal adjustments. Argentina offers a good example of this, as the central bank there just raised its policy interest rate to 45%. Clearly the yawning performance gap so far this year between the S&P 500® (hovering near its all-time highs and up about 7% year to date as of August 15) and EM equities (down about 11% year to date) is begging to be looked at from an asset allocation perspective. I think it's still too early, but at some point this will become an important action item for global investors.
What does all this mean for US markets? A few days ago it looked like the S&P 500® Index was ready to overtake its January highs, but the crisis in Turkey serves as a good reminder that there are still some big potential headwinds out there. The dollar is still strengthening versus many currencies, financial conditions remain on their tightening path and now it is starting to look more and more like earnings growth is putting in a post-tax cut cyclical peak at about 24%. US corporate earnings have been booming this year, helped in large part by the corporate tax cut. First quarter earnings2 were up 23% year-over-year and second-quarter earnings were up 24%.
This surge has been happening while earnings outside the US continue to decelerate from around 20% back down to the single digits. The boom in US earnings has enabled domestic equity market valuations to descend back down to earth without any pain so far in terms of stock prices. To wit, the forward P/E ratio for the S&P 500® is down 3 points in 6 months to 16.5x while the price index is basically unchanged after climbing back from a 10% dip early in the year. We have the earnings boom to thank for that. However, we are seeing signs that the rate of change for US earnings may be starting to peak. Unlike what happened in the first quarter—where earnings estimates gained across the board—the rise in second-quarter estimates seems to be coming at the expense of the third and fourth quarters.
Third-quarter estimates are down 230 basis points (bps) from their highest levels a few weeks ago, while estimates for the final quarter of 2018 are down 120 bps. That's not to say that the level of earnings is starting to decline, of course; just that they may have reached their peak growth rates for the year. This is not necessarily a risk for stocks, but it does mean that the valuation math likely will start to get incrementally less favorable from here. My expectation is that the stock market is not yet ready to break out to new highs and that we will remain in this lateral range for a while longer. There are simply still too many crosscurrents, with booming (but peaking) earnings growth on the one hand and tightening liquidity conditions resulting from the Fed cycle on the other. The result is a sideways market that could produce a healthy valuation reset.
I still expect that 2019 will be a pivotal year for stocks, as I think by then earnings growth should be back down in the single digits, while the Fed will likely be 3 or more hikes further into its cycle. If in 2019 the Fed is close to the end of its normalization path, US stocks could be in good shape to resume their epic bull market. But if inflation forces the Fed to go well beyond what is currently expected, the story could be much different. As I see it, the biggest threat to the US markets (outside of a rapidly escalating trade war or some geopolitical crisis) is inflation. If inflation heads north and forces the Fed to tighten substantially more than the market is discounting—at the same time that earnings growth is decelerating—then this could cause a significant tightening of financial conditions, an inversion in the yield curve, and further compression in P/E multiples. Without an earnings boom to compensate for such events, a serious decline in stock prices could result. Again, that does not represent my base case, but with the US economy heading toward late cycle, to me it's the scenario that poses the greatest risk to this 9-year-old bull market. For now, patience is a virtue.
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