The truth is there is not much to worry about the U.S. economy. There is not a single sentiment figure that is not positive or close to record high. And not only will EPS rise over 20% this year, but if analysts are correct, 2019 EPS will rise another 10%.
And as the chart below shows, while the current trailing P/E of the S&P 500 Index is about 23, the forward is about 18.
And since EPS is up over 20% and stocks are only up a fraction of that, we are witnessing a multiple compression that should limit any serious market decline. And if EPS raises another 10% in 2019, it's hard to see how a meaningful correction could happen, since the fundamentals more than support current valuations.
However, there are always things to worry about. No matter how good things are, there is always something that might come along and destroy a delicate balance.
In a nutshell, my concerns for the next 12-18 months are:
- Trade Wars
- Continued deterioration of Emerging Markets
- A Federal Reserve Policy Mistake
- A Rising Dollar
Please note all the above are a “risk-off” trade for markets.
The first things that worries me, is the trade crusade the U.S. administration has embarked on (AKA Trade Wars). Politics aside (if the U.S. administration is right or not), tariffs act as a tax and eventually will:
- Lower worldwide aggregate demand
- Lower economic activity
- Eventually, eat into profitability
At the moment, the market is not worried much about this issue. However, if these tariffs become permanent, they will cause financial and economic damage.
A Continued deterioration of Emerging Markets is also another concern. One of the reasons for this deterioration of the EM space obviously has to do with the current trade war between the U.S. and China, however, it is not the only reason.
EM markets have also been hurt by the rise of the dollar. By default, the U.S. administration aims to lower the U.S. trade deficit. And why is this bad? Well, because if it succeeds, it means a scarcity of dollars on a worldwide scale.
And why is this bad? Because the world needs a U.S. trade deficit (as does the U.S.), as I have described in a previous article (please consider: A Stronger Dollar Is Negative For Markets Around The World).
So long term if these trade wars persist, it might mean a much higher dollar, which means fewer dollars abroad, which means more pain for the EM space. Mind you, a continued deterioration of the EM space will also act as a headwind for the world economy.
And believe me, if these trade tensions don't end soon, and if the U.S. administration insists on a lower deficit, things will get a lot worse.
A Fed policy mistake is also another concern. More and more people are wondering when the Fed will stop raising rates and how high interest rates will rise. To be fair, even the fed itself does not know, having said many times that it is "data-dependent" and it is not predetermined as economists and the Fed were in the past.
Having said this, however, one has to wonder where the "neutral rate" is. No one seems to know. And while Fed Chairman Jerome Powell has a very good understanding of the mistakes the Fed has made in the past, at the end of the day, even he does not know when to stop raising rates. My fear is that the Fed raises rates more than needed, that will cause a lot of damage before it backs down. And to be honest, I think that rates are already too high.
However, there is also another type of Fed policy mistake that might happen, and it has very little to do with the Fed's mandate or the U.S economy. This is none other than the effect Fed policy has on the EM space, and other countries around the world.
According to the BIS, dollar denominated loans outside the jurisdiction of the Fed totaled $11.4 trillion in 2017. This means that as rates in the U.S. edge higher, so does the cost to service this debt outside the jurisdiction of the Fed.
Mind you, while economies like Turkey and Argentina have many internal reasons for their very bad performance in 2018, the truth is that a higher dollar exacerbates their situation.
And this is the main reason why EM markets have performed very badly in 2018 as depicted by the MSCI Emerging Markets ETF (EEM).
So why does the EM space need to concern the Fed? Because all economies are connected one way or another. For example, according to the BIS, Spanish banks have $28B exposure to Argentina, and about $80B in exposure to Turkey.
So while the U.S. has not been hurt yet, if this trade crises does not end soon, and if the Fed continues to raise rates, eventually many problems in the EM will spill over to many mature economies, that will eventually hurt the U.S. economy also.
So does the Fed take into consideration what happens to the rest of the world when setting policy? According to Fed Chairman Powell, it does.
On September 26, among other things, Federal Reserve Chairman Jerome Powell made the following comments:
We do understand, though, that when our economy is strong and we're raising rates, that puts upward pressure around the world and can affect countries, particularly countries that have external dollar borrowing
The performance of the emerging market economies really matters to us in carrying out our domestic mandate.
So if the Fed does take into consideration the damage interest rates hikes are doing to the EM space, then it better provide some forward guidance saying that its interest rate hiking cycle will end soon, or better yet, has ended. Otherwise, I see a lot more damage to the EM space, and sooner or later a spillover to mature markets. Yes, that includes the U.S.
Please note that all the above are a "risk-off trade" for the market. Even if no damage is done to the U.S. from the trade dispute and higher interest rates, the market will still be in risk-off mode. This despite the fact that EPS is supportive. This not only means a correction, but sooner or later, it will also dampen economic activity.
While every pundit on Bloomberg and CNBC keeps telling us interest rates are not a problem, they fail to see (in most cases) the damage interest rates are doing around the world.
I honestly believe Fed Chairman Powell does not want to overdo it, and does not want to be ahead of the curve, preferring to be at par with economic policy that the U.S. economy needs.
However, if this is the case, then he has to tell the market interest rates will not rise any more. Because if this "off-risk market mode" continues, eventually, it will cause damage and hurt EPS also.
EPS estimates for 2018 are probably still secure, but the 10% rise that analysts are forecasting for 2019 is subject to change, if the trade wars do not stop, and if interest rates continue higher.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.