After spending most of the year celebrating news of the booming economy, investors suddenly veered off course in October and shifted focus onto a growing list of potential concerns. On the positive side of the ledger, and arguably already baked into prices, were impressive earnings gains fueled by strong fundamentals and recent tax decreases. S&P corporate earnings are estimated to have risen almost 25% in the third quarter. That followed the 25% earnings gains already registered in the second quarter, making these the strongest two quarters since late 2010.
This rate of earnings growth is predictably leading to record growth in payrolls, low unemployment, increased capital spending and a nascent uptick in productivity. Animal spirits have been stirring for some time, leading to fresh market highs as recently as September, when the S&P 500 topped out above 2900 resulting in a year to date return of over 10%. As the table above details, however, market leadership was extremely narrow and focused almost exclusively in large cap growth stocks. Their gains were approaching twice that of the broader market with a return of 17.1% through September 30. Most other sectors, particularly those perceived to be more defensive, experienced much lower returns through the third quarter.
Of course, we know that all was not necessarily well beneath the rosy headlines. In our opinion, the list of under- appreciated threats includes rising interest rates, soaring corporate debt levels and the likelihood that we are approaching peak earnings momentum for the U.S. economy. There are also increasing fundamental questions about the sustainability of growth rates for market leaders like Facebook and Google. When these fears hit the so-called FANG stocks (Facebook, Amazon, Netflix and Google), the pillars of the long- term bull market, the broader market could not stand on its own with the October thrashing the result.
Hopes of synchronized global growth earlier this year, which might have helped extend the party for U.S. investors, are instead giving way to fears of a synchronized global deceleration today. Strategists’ predictions that the rest of the world would “catch up” to the U.S. rate of growth and market gains are starting to turn to the realization that the U.S. might instead “catch down” with global economies and valuation levels. If nothing else, we know the rate of change in the U.S. economy cannot be sustained and is expected to slow significantly in 2019. Following back-to-back quarters of 25% plus growth, it is only logical to expect more modest comparisons going forward. Sure enough, on third quarter earnings calls, managements have increasingly guided next year’s expectations down. The list of headwinds that have been sighted as contributing to a tougher operating environment is classic: record low unemployment, rising wage pressures, cost of goods increases throughout the supply chain, logistical bottlenecks, trade tariffs, and a stronger dollar.
As a result of these rising cost pressures and moderating sales growth, 2019 earnings estimates are trending down significantly compared to this year’s robust pace. While next year will still represent healthy growth, the strongest momentum is clearly behind the U.S. economy. While this deceleration does not necessarily presage a recession, it does warrant a more cautious outlook for future stock market returns, in our opinion.
As we have seen since the beginning of the post- election rally in 2016, positive fundamentals get priced into markets far ahead of their realization. However, when these expectations start to fade, as they did in October, that optimism can evaporate just quickly. Investor’s attentions have now begun to shift to the ramifications of tightening liquidity conditions and slowing momentum–likely a less benign investment environment.
One of the hallmarks of Radnor Capital’s investment philosophy is our focused portfolios comprised of quality companies. For us, that means a strong balance sheet, with reasonable debt levels and strong cash flows to support it. One of the most troubling aspects of the current environment, and one which seems to be getting less attention, is the surging level of debt on U.S. Corporate, government and personal balance sheets.
As the chart below shows, corporate debt levels have more than doubled since the best economic peak from roughly $3 trillion dollars to more than $6 trillion currently. As a result of this burgeoning debt, we are paying particular attention to the strength of balance sheets and capital allocation practices of the companies we own in portfolios.
As your portfolio managers, our job is not to make dramatic changes to portfolios in an attempt to time specific declines in the markets. However, based on our long- term orientation, we are currently emphasizing the defensive characteristics of our investment philosophy. October gave us an opportunity to revisit our portfolio holdings and confirm the sustainability of quality balance sheets and the achievement of long term earnings growth. In our fixed income portfolios, we are emphasizing high quality and keeping average maturities somewhat shorter than normal to protect against a continuation of tighter credit conditions. October’s market declines were very broad based with few places to hide. While our portfolios did see some losses, we feel confident that we can meet our client’s longer- term goals through attention to quality and protection in an increasingly turbulent environment.
As always, please give us a call if you would like to discuss your portfolio in more detail. We would also refer you to our third quarter market comments for a more thorough discussion of market fundamentals.
Radnor Capital Management, LLC (“RCM”) is a Registered Investment Advisor.
Opinions expressed are subject to change at any time, are not guaranteed and should not be considered investment advice.
The statements contained herein are based upon the opinions of RCM at the time of publication and are subject to change at any time without notice. This communication does not constitute investment advice and is for informational purposes only, is not intended to meet the objectives or suitability requirements of any specific individual or account and does not provide a guarantee that the investment objective of any model will be met.