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Late in the day Tuesday London time, news broke that the EU and UK had reached a draft Brexit withdrawal agreement. After weeks of rumors a deal was close, it appears negotiators reached a final text that has UK Prime Minister Theresa May’s backing. EU officials confirmed negotiators agreed on text, but they are refraining from calling it a “deal”—they are awaiting the UK cabinet’s reaction, apparently. Which is uncertain, and so are the terms included. All in all, though, while much is unknowable at this point, we see the potential deal as a small step toward the UK getting on with Brexit—a plus for stocks in Britain and Europe alike.
At this juncture, to call details about what this potential agreement contains “sparse” is a huge understatement. Across the four major UK publications and two US outlets we reviewed, we found nothing but speculation. The most detailed information we saw was from The Guardian, which noted “The principal document … runs to more than 400 pages of dense legal text.” Sounds gripping!
Media is broadly reporting senior members of May’s cabinet are reviewing the deal now, with an eye toward a full cabinet vote on the contents tomorrow (Wednesday) afternoon. From there, assuming May’s cabinet approves (which is not a sure thing, given disparate views on Brexit and many of the associated issues like the Irish border), a special EU “Brexit” summit would take place, with officials targeting late November. Assuming all that happens, the UK Parliament could vote on the deal before Christmas.
This baby tapir is unafraid of the ECB’s taper. (Photo by Artush/iStock by Getty Images.)
In 2011, with the eurozone still recovering from 2008 – 2009’s global recession, the ECB hiked rates twice—only for the economy to fall back into recession again as the eurozone’s sovereign debt crisis erupted. Many deemed the hikes a monetary mistake. With eurozone GDP growth easing to its slowest rate of this expansion in Q3, some worry the ECB’s move to reduce monthly asset purchases to €15 billion in October—and plans to end the program after December—are similarly ill-timed. If the ECB stops its monetary support, doesn’t that increase eurozone economic risks? In our view, no. Contrary to popular belief, we think the ECB’s eventual exit from quantitative easing (QE) should help, not hurt, the eurozone’s loan growth and economy—a positive surprise for eurozone stocks.
By the numbers, Q3 earnings season looks solid. By the headlines, not so much. Coverage hypes “peak earnings” and argues stocks can’t rise absent new “catalysts.” In our view, all this negativity merely reflects dour sentiment, typical during corrections. While backward-looking, Q3 earnings—and the media’s reaction to them—indicate fundamentals are still sunnier than most appreciate.
With 74% of S&P 500 firms reporting through November 2, FactSet data show Q3 earnings are on pace to rise 24.9% y/y, with 78% of firms beating expectations.[i] If this pace persists, Q3 would be the third straight quarter of 20%+ earnings growth.[ii] Revenues aren’t missing the party—they are up a solid 8.5% y/y thus far, with 61% of firms beating.[iii] All 11 sectors reported rising earnings and revenues—and 9 reported double-digit earnings growth.[iv] With an assist from recent volatility, higher earnings have pushed the S&P 500 forward price-to-earnings ratio down from 18.5 on January 26—the date the S&P 500 peaked before this winter’s correction—to 15.6 on November 2.[v] Given the prevalence of “valuations are too high” fears last year, one might have expected media to breathe a sigh of relief. But instead, the spotlight turned to new worries, like “peak earnings”—the notion companies are struggling to maintain profit growth now that the alleged tax cut sugar high has worn off.
True, expectations for Q4 earnings and revenue growth are lower—15.0% and 6.8% y/y, respectively—than Q3.[vi] But tax cuts have precious little to do with revenue, which has risen nicely this year. Besides, the idea corporate tax cuts gave some firms a one-time earnings boost isn’t sneaking up on markets. Forward-looking stocks knew all along the jolt was likely to skew earnings growth for a spell, then fade. Heck, headlines have been warning of this moment since before the tax bill crossed President Trump’s desk last December. To efficient markets, this is ancient history.
As always, our analysis is intentionally non-partisan, focusing on political developments' likely impact on stocks. We favor neither party nor any politician and generally consider partisan bias blinding—a big risk for investors.
And with that, midterms are in the books! The polls are closed, the ballots are being tallied, and early returns show the Republicans keeping the Senate while the Democrats pick up House seats—probably enough for control. Control didn’t swing radically in either direction. While both parties will probably claim victory, for investors, the real winner should be gridlock—and stocks, as midterms’ completion ushers in the most bullish part of the presidential cycle.
Overall, the contest went largely as we expected. The president’s party lost relative power, as is typical, although it doesn’t seem like the Democrats picked up vastly more than the historical average of 30.[i] Even if Republicans end up gaining a few more Senate seats than we thought likely, it doesn’t really change the balance of power. Whether they pick up two, four or more seats, the net result is likely still a split Congress, with very little of consequence passing over the next two years. Beltway insiders might spend weeks musing about the political implications of Indiana and Missouri’s Senate seats flipping to the GOP, but that is sociology—not a stock market issue. Same goes for the madcap four-way race to fill the Mississippi seat opened by Thad Cochran’s retirement, which heads to a November 27 runoff. Ditto, also, for the issue of whether Nancy Pelosi will survive a potential House leadership contest. The nitty gritty of who won where means far, far less to stocks than the upshot of gridlock, in our view.
Eurozone GDP grew 0.8% annualized in Q3—the slowest growth of its five-and-a-half-year expansion—sparking recession worries and more jitters for eurozone stocks.[i] October’s composite purchasing managers’ indexes (PMIs), which hit their lowest level in two-plus years in the eurozone and showed contraction in Italy, added more fuel to the fire. However, we think extrapolating a recession from two data points is a mite hasty. To us, all of this speculation speaks to overly dour sentiment toward the eurozone, rather than presenting good reasons to be pessimistic about eurozone stocks. Stocks typically look forward, not backward, and have likely already moved on from the summer slowdown.
First off, we think it is important to note eurozone data weren’t weak across the board. Of the handful of countries reporting thus far, France accelerated. So did Spain and Austria. Italy slowed to 0.0% q/q (0.1% annualized), so most fears centered there, presuming falling industrial production meant tariffs were starting to bite.[ii] Similar fears surround Germany, which hasn’t reported GDP yet but is widely expected to show slowing growth. To us, it seems like a stretch to presume recession looms and eurozone stocks will sink further as they price it in. There are plenty of potential benign reasons for slower GDP, including things like strong imports. Imports represent domestic demand—a positive—but GDP math counts them as negative. Or maybe private inventories fell as strong demand surprised suppliers. Another potentially positive explanation could be weaker government spending masking stronger private sector growth. Yes, there could be negative reasons too—it is entirely possible domestic demand sagged a bit. Our point is simply that it is too soon to know either way. Without knowing details on the various components (consumer spending, private investment, trade, government spending), it is impossible to draw sweeping conclusions.
While GDP data garners lots of attention, it doesn’t move one-to-one with stocks. The economy isn’t the stock market. A share of stock represents a slice of a company’s future earnings. But economies represent all commerce—public and private companies, self-employed folks, government and investment. GDP is an imperfect attempt at tallying that. In addition, the data are inherently backward looking. Releases cover old news, reporting details of economic activity in the previous quarter. But one quarter’s GDP doesn’t predict the next. Now people are latching onto October PMIs as evidence of further weakness, but PMIs don’t measure growth’s magnitude. They tell you what percentage of firms grew, but not by how much. About the only takeaway is that with the eurozone composite PMI presently at 53, more firms are growing than not—and, while narrower than previously, by a still-comfortable margin.
After trailing in 2016 and 2017, global Health Care stocks are outperforming nicely this year—up 7.2% year to date, versus the MSCI World Index’s -1.4% decline—as investors are finally starting to appreciate their positive fundamentals.[i] While the sector—and particularly Pharmaceuticals—had plenty going for it in prior years, political fears over price controls and efforts to repeal the Affordable Care Act weighed on sentiment. More recently, investors fretted potential patent expirations and the president’s Twitter attacks on several Health Care companies. However, thus far, none of these fears have translated to actual policy, and firms have taken expiring patents in stride, allowing sentiment toward Health Care to start healing. As fears continue fading, we believe Health Care should continue benefiting from still underappreciated improvement—including new drug approvals and booming drug innovation.
Thanks to a more favorable regulatory environment, 2018 drug approvals have been strong. The Food and Drug Administration (FDA) approved 47 new drugs in 2018’s first 10 months—more than doubling the full-year average since 1999 and on pace to break 1996’s record (53)—as shown in Exhibit 1, which tracks approval of New Molecular Entities, or drugs that weren’t previously approved (i.e., not generic versions of existing drugs). This sharp jump stems partly from a more streamlined drug-approval process. In December 2016, President Obama signed the 21st Century Cures Act, expanding funding to the National Institutes of Health for clinical research and liberalizing the types of clinical trials the FDA can accept as evidence of a drug’s efficacy. In short, the law simplifies drug approvals. In our view, this regulatory easing—a positive for Pharmaceuticals companies—is still widely underappreciated.
Exhibit 1: FDA Approvals for New Molecular Entities
With Q4 underway and midterm elections just days away, US stocks are entering a historically bullish three-quarter stretch, as Ken Fisher discussed in his June 3 USA Today column and this video. Since 1926, S&P 500 returns during Q4 of the midterm year—and each of the subsequent two quarters—have been positive 87% of the time, far above stocks’ non-midterm 64.6% quarterly frequency of positivity.[i] In the 23 historical nine-month periods between September 30 of a midterm year and the subsequent June 30, US stocks rose 21 times—a 91.3% frequency. But this year, markets’ rocky October—in which the S&P 500 fell -6.9%—has some wondering if midterms’ bullish impact has been preempted.[ii] In our view, there is little reason to suspect so at this point. Weakness in advance of US midterm elections is surprisingly common. The S&P 500 declined in eight midterm-year Octobers since 1926.[iii] Q4 finished negative just twice. The nine-month period? Only once—in 1930. Simply, seeing weakness at times—especially ahead of the vote—isn’t uncommon. The following are charts of the S&P 500 for every midterm year and subsequent two quarters going back to 1962. You have to go all the way back to 1958 to find an example where the market didn’t experience some sort of weakness in advance of the midterm election. In our view, this illustrates the fact weakness before the vote doesn’t negate midterms’ bullish impact.
Exhibit 1: 1962 – 1963
Q3 US GDP rose 3.5% annualized—a slowdown from Q2’s 4.2% but still good for the third-fastest rate in four years.[i] The report had something for everybody. Optimists cheered the strongest consumer spending since Q4 2014, while pessimists groaned about the weakest business investment since 2016. Pols on both sides of the aisle found talking points: Economic growth is on track to hit the Trump administration’s 3% target, but trade policy was a headwind slamming certain industries. For investors, we suggest stripping away the narratives. Q3’s GDP report had plenty of interesting tidbits, but overall, the broader picture remains the same: The US economy remains on firm footing, bolstered by its strong private sector and domestic demand.
Here is a table comparing how Q3 figures squared up with Q2’s.
Exhibit 1: A Tale of the Tape
Stocks gave investors a treat on Halloween, continuing a nascent (potential) rebound from Monday’s low. Only time will tell whether this is a false positive or the start of an actual recovery, but in the meantime, headlines offered a witches' brew of spooky stories. We saw China hard landing ghouls, tariff vampires, Italian debt poltergeists and rising interest rate bogeymen—basically, the same gaggle of spooky characters that makes the rounds whenever markets get rocky. In our view, the rehashing of old ghost stories is a good sign stocks’ lousy October is a short-term drop—painful but normal in bull markets—rather than the start of a deeper, longer, fundamentally driven bear market. To see why none of these spooks is an actual monster under markets’ bed, read on.
The Curse of the Chinese Slowdown
Yes, Chinese GDP growth slowed to 6.5% y/y in Q3, and October’s purchasing managers’ indexes hit a two-year low. The popular narrative holds that tariffs are biting the world’s second-largest economy, and its troubles will soon infect the rest of the world as demand sinks.
In this podcast, Client Communications Group Vice President Naj Srinivas speaks with Fisher Investments’ founder, Executive Chairman and Co-Chief Investment Officer Ken Fisher about market volatility so far in 2018.
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