The outlook for markets into 2020
How will earnings, tariffs and interest rates affect the markets?
Published July 12 2019
Linda Duessel: Hello, and welcome to the "Hear & Now" podcast. I'm Linda Duessel, senior equity strategist at Federated Investors. Today I'm joined by Phil Orlando, chief equity market strategist at Federated, and R.J. Gallo, senior fixed income portfolio manager. We are here to discuss market outlook headed into 2020.
Linda Duessel: Let's turn now to you Phil, we hear a lot about the impact of President Trump's tariffs in the media, but does Main Street care about tariffs? Does the stock market care about tariffs? Do tariffs really have the potential to end this now longest-ever U.S. expansion?
Phil Orlando: I mean, that's a great question Linda. I think this is one of the most important and probably one of the most misunderstood aspects of the markets and the economy right now. I'm going to take your use of the word tariffs as code for the China/U.S. trade negotiation. Our view, and this may not be a consensus view, is that Trump is utilizing these discussions as a means of narrowing our balance of trade deficit, which is running about $600 billion a year, costing the U.S. economy about three percentage points of growth.
Phil Orlando: I think he is looking at the opportunity, specifically with China, to cut that trade deficit in half and boost GDP maybe by 100 basis points, one percentage point in 2020. We were rocky there in the month of May and June. We think we've got those talks back on track based upon the results of the recent G20 summit meeting.
Phil Orlando: We'll see later in the year if we can get that trade deal consummated. No harm, no foul if we can get it done. All of what we've gone through this year is tolerable, but if this deal blows up and the tariffs become permanent and prices are higher and GDP growth is diminished, that becomes a whole different kettle of fish.
R.J. Gallo: Yeah, I think the trade policy uncertainty that has largely been wrought on the global economy by the Trump administration is tactical in nature, they're doing it for a reason, I don't question that at all. Personally, I question whether or not they're going to get the results that they want. We've had a lot of starting and stopping in the China/U.S. trade negotiation.
R.J. Gallo: This most recent thing is just another chapter in the starting and the stopping. It's hard for the bond market I think to get too excited. I mean, the 10 year Treasury is at the same level it was before the G20 meeting. The bond market is not saying, "Ooh, there was something big that happened in Osaka." They're like, "Okay, more of the same, they're going to keep talking."
R.J. Gallo: The keep talking approach doesn't seem to be yielding enough results with respect to China. I do think it's interesting. Linda, in your question you used the word tariffs. I mean, president Trump says, "I'm a tariff man," that's a direct quote off of Twitter of course. He used tariffs in a very unorthodox way with respect to immigration policy in Mexico.
R.J. Gallo: He believes it's getting some results. Mexico, according to papers this morning, has brought out more forces to try to prevent Central American refugees from heading north without being encumbered. I think when President Trump sees what he perceives as progress on key issues as he uses tariffs as a weapon, we in the market have to at least be cautious about the fact that they'll be more wielding of those same tariffs in the future.
R.J. Gallo: Whether it's with respect to China or somebody else on some other policy issue. That is partly what May was all about. The idea that you're going to use tariffs to get action on immigration policy was a pretty novel one.
Linda Duessel: Right.
R.J. Gallo: In your question you asked about Main Street caring about tariffs, maybe not so much yet. I think CFOs and CEOs, the C suite, they care about tariffs. There's a lot of concern that companies that are being asked to commit capital to foster further expansion to keep this long expansion extending, there's a lot of concern that in the end the uncertainty in the global trade system is going to depress investment first.
R.J. Gallo: Even though rates are low, interest rates maybe low, but that's the only thing people care about when they make investment decisions. If they have a lot of policy uncertainty with respect to trade and global growth, that could in and of itself be sand in the wheels of economic-
Linda Duessel: Right.
Phil Orlando: We've already started to see that. Some of the confidence metrics, consumer confidence metric I would argue, a whole host of manufacturing metrics are slower today than they were 6 or 12 months ago, in my opinion because to the uncertainty regarding China/U.S. trade.
R.J. Gallo: All the isms, yeah, exactly.
Linda Duessel: Well, and actually very, very good points all, but R.J. beyond the tariff question, market skeptics are pointing to other political risks that could threaten the financial markets confidence. For example, the other facets of the so-called U.S./China trade war, Iran, Brexit, what's your view?
R.J. Gallo: I think that I don't disagree with Phil one bit that President Trump wants to shrink trade deficits. He has a unique brand of politics, and I think he wants workers who voted for him to move forward and feel that the trade situation is going to help them. Right now they're taking some pain, but if it's for long-term gain, they might perceive it as being worth it.
R.J. Gallo: I do think the U.S./China situation, you're hearing academics, for example, suggest this is a new Cold War, that this is not an isolated trade confrontation. That President Trump's administration led, for example, by the view of one of his advisors, Navarro, that they view China's ascendancy as a threat to the United States and it's not solely about trade.
R.J. Gallo: You're seeing that with the role of ... I'm terrible at pronouncing Huawei, their tech company, the concerns about U.S. losing intellectual property via theft to China and that, that becoming a national security issue. It goes beyond trade, so I think that, that's something that we're going to be talking about for years to come.
R.J. Gallo: The Brexit situation, to me, Brexit is not the fear that it once was. Brexit was a fear in 2016, because the idea that a European Union member would vote to pull out of the union opened the door to a European currency member doing the same, which would be a massive systemic risk. That hasn't happened, the voting within Europe, mainland Europe, the participants in the currency, have not opened the door towards a withdrawal from the EU, or from the Euro.
R.J. Gallo: That's all good, but it is an economic problem for Europe, because Europe's already slow. The ECB is talking about more accommodation, because they're just not growing fast enough. A hard Brexit, that's a big trading partner. That's just yet another problem, another head wind to European growth, that matters. The Iran situation is a festering problem.
R.J. Gallo: It seems like both sides, Tehran and Washington, don't want a hot war. It's certainly warming up, and I don't think we'll end up in a shooting war with Iran, but ever since the Trump administration pulled out of the 2015 Nuclear Accords, it opened the door to eventually this was going to heat up and become more complicated.
R.J. Gallo: That's where it is today. Just in the papers today, Iran has now gone over its uranium stockpiles. That suggests that this is going to continue, this is not a one-act play.
Linda Duessel: Yeah, wow, wow, so many political and geopolitical risks. Phil, as we enter the second half of this year and think about where the S&P 500 should go and we're at record highs now, do you think corporate earnings here in the U.S. will strengthen enough for the S&P to reach your year-end target?
Phil Orlando: The short answer is yes, but it's not going to be a straight line. You look at the first quarter of this year, expectations going into the quarters that earnings were going to be down 3% to 5%. We ended up being up 2.5%. Then the second quarter, which is going to start on July 16, the expectation is that earnings are going to be down another 2% to 3%.
Phil Orlando: We're thinking they're going to be up another 1% to 2%. Similar story in the third quarter, so what's happening I think, companies are being appropriately cautious, because of the things we've talked about. What's going on in Europe, what's going on with China trade, what's going on in the Middle East. Companies, I think, at the end of the day when the dust settles on second quarter and the full year, the earnings for the S&P 500 are going to be up around $165, $170.
Phil Orlando: Now, the key thing for us is going to be that ... R.J. touched upon this, interest rates and inflation are relatively benign. That we've got benchmark 10 [year Treasury] sitting at 2% give or take. We've got core PC inflation sitting at 1.6%. We'd probably go to church and light candles if we can get that up to 2% by the end of the year. Maybe you're talking about let's call it 2% inflation trends and Treasury yields.
Phil Orlando: In that kind of an environment the appropriate price-earnings ratio on stocks should be somewhere in the neighborhood of about 18, 18.5 times earnings, in which case, if we can do $165, $170 in earnings, if inflation and interest rates stay benign, if we get that 18, 18.5 multiple, we're looking at a 3100 year-end stock price in the S&P, so we're feeling really good.
Phil Orlando: Now that's not to say we're going to go straight there. We could absolutely see a little bit of an air pocket here over the summer months, or the early fall based upon some of the things we've talked about. A misstep on China trade, does something happen in the Middle East? Does the Fed disappoint us on July 31? There's any number of things that could happen.
Phil Orlando: We think that even if we get a little bit of an air pocket here, that might represent an opportunity to add if you're under invested. We do think we get to 3100 by the end of the year.
Linda Duessel: Excellent, R.J. in my travels I often tell advisors ... I work on the equity side, I think it's cool to be on the equity side, they're so much more fun than the curmudgeons over on the bond side. Having said that, I always remind myself and I always remind people that, but the bond market is so good historically though at calling the economy.
Linda Duessel: So much has been written about the yield curve's historic record of calling for recessions. Now do you believe that the recent yield curve inversions that we have seen are signaling an upcoming recession?
R.J. Gallo: I think it's inevitable that this 10-year expansion will come to the end. I don't think the recession is this year, probably not next year. I think the yield curve inversion that gets most of the academic modeling and the market focused outside of the bond market, tends to be the three month bill yield relative to the 10-year treasury, and that is still inverted right now.
R.J. Gallo: That inversion, however, has been moderating. It's -10 basis points, it was deeper, it was -22, -23. Why is that? Once the Fed opens up the door to easing potentially in July, which is within three months, the 3-month bill yield has started to go down helping to correct the inversion. I'm looking on a screen right now, the 2's, 10-year, positive 23.
R.J. Gallo: The 2- to 30-year Treasury, positive 75. The 5- to 10-year, positive 23. More market determined yield curves. The 2-year is a 2-year security, it looks beyond just three months. It's not inverted to the 10-year at all, in fact, it's a positive 20. I think that the inversion that we're focusing on is part of what the Fed is seeing, part of why the Fed maybe, as we mentioned at the start of this, be getting boxed in and maybe forced into an ease, even if they're not that worried currently.
R.J. Gallo: As they do so, that inversion will be rectified.
Phil Orlando: We've got a proprietary recession model that we developed over on the equity side. Steve Chiavarone put the model together for us. Our model is concluding that the U.S. economy was not in recession last year. We don't think we're in recession this year. We don't think we're going into recession next year. We are concerned at the earliest that we could be looking at a risk of recession the first half of 2021.
Phil Orlando: Now, you look at the portion of the yield curve and we like to look at the relationship between 10-year Treasuries and the funds rate. Right now that's showing about a 50 basis point inversion. When you study the history of that and say, "Okay, what kind of a signal is that giving us?" The answer is that it takes about 20 months on average once we get an inversion of funds to 10's before the economy goes into recession.
Phil Orlando: Well that inversion occurred last month in June, add 20 months to that, and that gets us to the first half of 2021. I think they're both right. I think the inversion is telling us that a slowdown is coming. Our model is saying that slowdown is not going to happen until the first half of '21, and that's where we think is the sweet spot.
Linda Duessel: Excellent, excellent, and carrying on though R.J., following up on the message of the yield curve, why do Treasury yields remain so low, confounding so many market observers?
R.J. Gallo: It's probably a long answer to that, but in brief once the Fed tapered their bond purchases in 2013, there was this fear that bond yields were going to revert back to 5%. At that time, I stood up in front of the sales force of the organization, my fellow investment colleagues, Bill Ehling and I put together a presentation. We said, "You know what? It's highly unlikely that yields in the market are going to revert to what we think of as pre-crisis norms."
R.J. Gallo: That the developed world, generally speaking, has a demographic situation that suggests that potential growth will be slower, in part because there's more retirees, in part because work force participation is low. Productivity, although it's been increasing lately, is still not as strong as it was decades ago. A low growth, mature, somewhat older developed world suggests lower rates of potential growth here and abroad, lower rates of potential growth, and relatively benign inflation due to global integration, trade and more flexible labor markets should mean equilibrium long-term interest rates.
R.J. Gallo: We'd be lucky if we got to 4 on the 10-year Treasury. We got to 3.25, and the stock market screamed bloody murder. If markets, the collective wisdom of crowds are sniffing out what our equilibrium interest rates, the signal they sent at that time was they are not 4, and they sure as heck aren't 5. We're back at 2, a striking turnabout.
R.J. Gallo: From a duration standpoint, we got to neutral for the first time in many years in terms of any extended period of time. We were neutral around Brexit, which worked out okay. We got to neutral around 2.50 on the 10-year. Our view is we are in a lower trajectory of market yields likely for years to come. That the relevant range might be 4 on the very high-end.
R.J. Gallo: It doesn't seem likely in the near term. If we're getting a recession in the next couple of years, the chances the Fed wanting to tighten anymore are low. If anything, we've talked about it in this discussion that we think they're going to ease. Lower yields are the new normal to borrow a phrase from one of our competitors in the industry.
R.J. Gallo: I don't think there's anything wrong with that. If you look over longer-term history, go back to the '50s and '60s, we had 10-year Treasury yields with two handles all the time. Perhaps the abhorrence was most vivid in the '70s when you had the guns and butter of the '60s, the heating up of inflation. An irresponsible Fed that was beaten up by the Nixon White House that stayed too easy as inflation built.
R.J. Gallo: In essence, we had unusually high nominal interest rates for much of the careers of the people who are in the industry now, especially those who are 50 and older, we remember that. It's hard for us to shake that off. I think it's interesting talking to people who are younger in the industry, they seem less worried about the interest rate environment, because they came up in a time when yields have remained relatively low.
R.J. Gallo: I think they're apt to remain in a lower range going forward. That doesn't mean they won't go up and down. That doesn't mean we won't have opportunities to tactically go long, short or neutral to make a little bit of money on the bond side. I'm not fretting that 5% or 6% is in the offering anytime soon. We're probably going to stay in the lower range that we're in now for a while.
Phil Orlando: I think there's another aspect to this discussion. Everything that R.J. just said was completely right, but I want to widen the purview of our discussion to looking internationally, specifically at Germany and Japan. If you're a global sovereign bond investor and you need a high quality piece of paper, you've really got three choices, you've got Germany, you've got Japan, you've got the United States.
Phil Orlando: Right now there are significant economic concerns in Germany and Japan. Are those economies rolling over? Based [off] of everything that's going on in Europe, the whole Brexit discussion, the transition with Mario Draghi, what the impact is on the German industrial complex. You've got German bunds right now that are yielding a -30 basis points, a record low rate.
Phil Orlando: Now, Japan on their hand, is contemplating whether or not to increase their value added tax for the third time. It would go from 8% to 10% at Halloween if they decide to do this. The last two times the Japanese increased the VAT tax, Japanese economy went into recession. As a result, JGB yields are sitting in a -20 basis points, again, a record low.
Phil Orlando: Again, in both instances the markets are saying that there are risk points in both of those economies. Again, if you need to invest some money in a global sovereign 10-year Treasury type instrument, Germany's -30 basis points, Japan's -20 basis points, all that buying pressure is coming into the United States, which is forcing our Treasury yield prices up and the yields down, we're not sitting at 2%.
Phil Orlando: While the economic discussion domestically that R.J. just laid out is perfectly accurate, I think it's an underappreciated phenomenon that the competitive pressures for the negative yields in Germany and Japan are also forcing our yields lower, which is to say that if we can get Germany and Japan's economy's back on track and those yields get back to neutral and then get back to positive, that theoretically should lift U.S. yields as well as all those yields are working in concert.
Linda Duessel: Well, as we get close to the end of our time together here, I'm remembering that I'm an equity girl, and were just upbeat people. One thing about Linda, Linda always needs a new pair of shoes. I need a new pair of shoes, and when I go shopping it really irks me when I am vying for the same pair of shoes with somebody else. Indeed Phil, it seems that the consumer out there is perfectly willing to spend.
Linda Duessel: Meanwhile, manufacturing numbers have disappointed this year. What do you make of this apparent disconnect?
Phil Orlando: I think you've accurately captured disconnect, but I think it's easily understandable. That you look at the consumer first, and the retail sales numbers in December and in February were terrible, there's no way for me to happy talk around that. I think I understand why they were bad. You had a negative wealth effect in the fourth quarter with the market collapse.
Phil Orlando: You had the uncertainty over trade, you had the government shutdown, and as a result we ended up with terrible retail sales numbers. Now as we studied that situation, we felt it was abhorrent, and we felt we would see a very strong snapback in the Easter season, what we refer to as “Mapril,” the combination of March, April retail sales.
Phil Orlando: Guess what? We got a very strong snapback. May was also very strong, so I think the consumer is back on track. Now you're quite right, the manufacturing numbers have been terrible, and we touched upon that earlier. The isms are bad, durable goods have been a problem, factory orders, inventory numbers, they're all suggesting problems in manufacturing.
Phil Orlando: To some degree I think that the uncertainty associated with what's going on with this China/U.S. trade discussions and Fed policy has put the manufacturing companies in a position that they don't really know what should we invest, what CapEx investment should we make? Should we hire more people? Should we raise their wages?
Phil Orlando: Should we do a bond offering? I think there's just a tremendous amount of uncertainty, that in our view will dissipate once we figure out exactly what the Fed's doing and where we are with this China/U.S. trade negotiation. I'm not overly pessimistic that the manufacturing cycle is dead. I think right now it's just wounded and waiting and watching.
Phil Orlando: I think if we can get some closure on some of these key discussion points, we can see an improvement in manufacturing later this year or into 2020.
R.J. Gallo: I would agree with Phil. I think that the rolling over of the isms broadly speaking in the developed world, and also in the developing world, it coincided with the uncertainty generated around trade policy led by the Trump administration. I think the Trump administration has a goal here where they're trying to tactically remake the way that some companies do business.
R.J. Gallo: They are very happy to see companies moving production out of China to personally, it doesn't have to be back in the United States. I think they're happy to see it to go to other countries as well, because it goes back to what I was saying before. I think the Trump administration views the ascendancy of China as a threat, and they would like to find ways to slow down that ascendancy.
R.J. Gallo: One way to do that is to get capital to move out of the country and go to other countries, ours or other non-U.S. production centers. It doesn't come without a cost however. If you're actually causing supply chains to be remapped and adjusted, we shouldn't be too shocked that the isms, that the manufacturing momentum erodes in the face of those types of changes and uncertainties that have arisen.
R.J. Gallo: If we're successful at, we as a country are successful at continuing this economic expansion, then it does seem quite likely that the dip in the numbers will actually be just that, be a dip, and that the expansion will continue and manufacturing will get some wind at its back again going forward.
Linda Duessel: Thank you, so Phil, any final thoughts?
Phil Orlando: Yeah, thank you Linda, you've done a great job moderating this by the way. Let me take two steps back and look at a bigger picture. As we were having this discussion last Christmas, the equity market was in a free fall and there was a lot of hand wringing. Our view was that the market was dramatically oversold. We had terrible toxic sentiment, but the underlying fundamentals of the market were in pretty good shape.
Phil Orlando: We thought that stocks would enjoy a powerful rebound rally this year. We thought we'd be up 32% over the course of the year. Guess what? We're now sitting, we're up 26%, stock market's at all-time record highs. As I sit here right now, I think the market may be a little bit ahead of itself given the concerns that we've talked about today, what's going on with the Fed, what's going on with China/U.S. trade negotiations, what's going on with manufacturing, what's going on with those overseas issues.
Phil Orlando: I think there could be some chop to the market in what's typically a perilous time in the cycle, the summer, the early fall. I think ultimately we will get through those issues, corporate earnings will stay slightly positive, start to improve towards the end of the year. Inflation and interest rates will remain benign, so I think we're going to enjoy a nice end of year rally.
Phil Orlando: I think we will get to our 3100 level on the S&P by the end of the year. I'm just a little cautious here over the summer months. There could be a little chop, but I think we end the year exactly where we want to be.
Linda Duessel: Thank you, and you R.J., any final thoughts?
R.J. Gallo: I think that the key going forward will be whether or not the politics and the policy uncertainties can be resolved in a way that are constructive for markets. I think the Trump administration has been, going back a couple years now since they got in place, they've rewarded capital. Cutting taxes increases the after-tax return to capital.
R.J. Gallo: Capital holders, i.e. the stock market, love that. It helped to propel the stock market higher, it makes all the sense in the world. The deficit on the other hand has not gone down, it's only gotten bigger. Can we find a policy equilibrium where we as a country ... I believe we should still care about deficits. I find it frightening theories like modern monetary theory, Dick Cheney saying 15, 20 years ago, deficits don't matter.
R.J. Gallo: I think that, that is a very myopic view. They don't matter until they do, and when they do you really regret that you've had a structural one for as long as we have. I think both parties, we're heading into a presidential election cycle. I think both parties don't seem to talk about deficits. It doesn't seem to matter anymore, and I worry a little bit as an investor that we've lost some of our netting.
R.J. Gallo: Fiscal discipline is so clearly out that, that's a problem. I think as a country we'd be better off if we found a balance between our federal resources private sector returns to capital, so that we could have a budget surplus again sometime. I know that sounds funny, but it was in the '90s that we actually had one. Under Bill Clinton and Newt Gingrich's collective leadership, we actually had a budget surplus.
R.J. Gallo: It unleashed a period of economic prosperity that we could have yet again. We just don't seem to have the discipline anymore, and I worry as an investor that we're going to pay some of that price. The uncertainty at the federal level in terms of policy will become a problem in the long run.
Linda Duessel: Well thank you Phil and R.J., very interesting discussion today. Thank you to those of you who've listened in. We look forward to you joining us again.