Jan. 28, 2019
Anyone searching for positive news about the global economy faces a tough challenge right now: Fading projections for corporate earnings and downbeat readings on growth suggest the outlook is dimming.
Yet, despite the steady drizzle of gloom during the first few weeks of 2019, investors have turned downright sunny. In both Canada and the United States, stock markets have marched higher since New Year’s Day.
This is not as crazy as it sounds. Several forecasters say the swoon in stock prices late last year set up markets for a healthy and sustained rebound this year. If political clashes over Brexit or China-U.S. trade don’t derail the global economy, the optimists could well be right.
One of the most articulate bulls is Robert Buckland, global equity strategist at Citigroup. In a report this week, he predicted global stocks will gain 14 per cent over the course of this year despite the slowdown he expects in corporate earnings growth.
Falling forecasts for earnings often go hand in hand with rising share prices, he pointed out. By his reckoning, there have been 15 years since 1989 in which earnings forecasts have been revised down but stocks have gone up.
Pessimism about the outlook for corporate earnings is already baked into today’s share prices, Mr. Buckland said. “The sell-off in [the fourth quarter of 2018] was all about investors anticipating earnings-per-share downgrades in 2019,” he averred. “We think that global equities are now pricing in a 1-per-cent earnings-per-share contraction for the year.”
His view is that analysts will probably continue to chop their earnings forecasts over the course of the year and that markets will shrug off the cuts. This is not just wishful thinking: Analysts are usually too optimistic at the start of the year and trim their forecasts as the year proceeds; as long as the cuts are under 10 per cent, share prices can still advance, according to Mr. Buckland’s analysis of market behaviour over the past three decades.
Given his belief that this year of forecast revisions will amount to a relatively mild 4 per cent, he argues that share prices around the world are more likely to go up than down over the next few months – “as long as there isn’t a full-blown global recession.”
This, of course, amounts to a fairly major loophole. And it is certainly possible to point to reasons for worry about what lies ahead.
Nobel laureate Paul Krugman has warned about the possibility of what he terms a “smorgasbord recession.” This would be a downturn caused by several discrete problems, none of them individually overwhelming but cumulatively debilitating. Brexit, slowing Chinese growth, trade wars and eurozone fiscal tensions are among the issues that could collectively overwhelm global growth.
A more specific reason for concern is a disappointing run of manufacturing readings around the world. The early, or “flash,” versions of the IHS Markit Purchasing Managers' Index (PMI) for January indicate declines in Japanese and euro zone factory activity. Coupled with lackluster readings on U.S. economic activity, the PMIs suggest year-over-year growth in advanced economies will drop below 2 per cent in the first quarter, according to Capital Economics, a London-based forecaster.
“We have long thought that the world economy would slow significantly in 2019, but the flash PMIs for January provide an early sign that growth may be deteriorating more quickly than even we had assumed,” global economist Simon MacAdam wrote this week.
The team at Capital Economics suggests that now is a good time to load up on high-grade bonds and other refuges from economic chaos, such as the U.S. dollar, Japanese yen, and gold.
Still, a recession is far from a done deal. The Bank of Canada, for instance, is at least modestly upbeat. It has taken note of falling oil prices and downgraded its forecast for economic growth this year to 1.7 per cent, but it predicts a rebound to 2.1 per cent in 2020.
In the United States, Bloomberg’s economic surprise monitor shows that many readings on industrial production, retail sales, real estate and the broad economy are falling short of forecasters' expectations. However, gauges related to households and the jobs market are handily beating forecasters.
For investors, trying to interpret this patchy picture is an impossible task. But one reason to buy into the bullish case is the lack of obvious excesses such as those that preceded the financial crisis or the dot-com crash.
Most major stock markets appear reasonably priced when you compare share prices with expected earnings over the year to come. Canadian stocks, for instance, are at their cheapest valuations since 2013 by this measure.
Even noted bears are detecting potential. GMO LLC, a money manager in Boston renowned for its pessimistic take on markets in recent years, sounded uncharacteristically enthusiastic in a quarterly report this week. “The poor returns over the past year have a silver lining,” wrote Ben Inker, head of asset allocation at the company. Many assets are now priced at levels that should deliver decent long-term returns. “In general, it looks to be the best opportunity set we have seen since 2009,” he said.
Both Mr. Inker and Mr. Buckland make a similar point: The reason to be optimistic about stocks right now is precisely because expectations are so low.
For his part, Mr. Buckland is happy to acknowledge the gathering gloom. He points out that Citi’s Earnings Revision Index, which tracks the number of analyst upgrades and downgrades around the world, recently sank to its most negative reading since 2009. “It looks especially bad in the U.S. and continental Europe,” he says.
But that doesn’t shake his faith that the market can still advance. Barring that global recession, of course.