On Thursday February 22, Goldman Sachs wrote in a note to clients that the economic macro data as likely to be “as good as it gets.”
This isn’t, in my opinion, a call for an immediate plunge in the markets. But with U.S. stocks trading near all time highs, I think the Goldman note is something all investors need to take seriously.
Or at least the question it raises needs to be taken seriously.
Here’s the question: If stocks are at all time highs and the economic data on economic growth, inflation, interest rates, etc. are as good as they’re going to get for this cycle, why should stocks move higher?
For stocks to go higher, we need either improving economic factors or an increase in positive investor sentiment.
Here’s the current economic picture. In the Fed’s recently released minutes from its January 31 meeting the U.S. central bank raised its forecast for economic growth in 2018 to 2.5%. Inflation remains below the Fed’s 2% target but is inching closer to that level, and the Fed sees inflation pushing above 2% in 2018. The Fed is likely to raise interest rates a minimum of two times and a maximum of four times in 2018. The yield on the 10-year Treasury note finished Friday, February 23 at 2.87%. The consensus among economists is that at 3% or maybe it’s 3.25% higher interest rates will start to slow the economy.
To imagine that U.S. stocks will move up on the economic fundamentals you have to believe in some improvement in that consensus forecast. I don’t see inflation or interest rates running wild, but I don’t see solid reasons to argue with the forecast. The one place the consensus forecast might be low is the growth rate for the U.S. economy. The Tax Cuts and Jobs Act could indeed deliver growth above 3% as its advocates claimed in their justification for that legislation. I’m skeptical that growth will accelerate to that degree. I’m even more skeptical that economic growth could accelerate to 3% and not push up inflation and interest rates beyond the current forecast.
And where do we stand on investor sentiment? A positive attitude toward the future can make investors willing to pay a higher multiple for current and forecast earnings. Which would drive stocks higher even if the economic fundamentals aren’t supplying much in the way of fuel. But the numbers we’re seeing on various measures of investor sentiment point to what Goldman calls “peak sentiment.” There may not be much more that sentiment can do for stocks from here.
The one macro fundamental that I see with significant upside from here is corporate earnings. Because of the lower tax rates in the Tax Cuts and Jobs Act, companies are going to see a big one-time reduction in their effective tax rates in 2018 from what they paid in 2017. Proponents of the tax cut bill saw companies investing that reduction in more hiring, more equipment, more R&D that would drive economic growth higher. I think it’s as likely that companies will use those savings to raise dividends and increase stock buy backs. But in either case–and especially if the tax savings get put into buy backs and dividends–we’re looking at a pretty hefty boost to numbers such as earnings per share and dividend yields in 2018.
The problem, of course, is that unless those tax savings do actually get put into investments that increase future revenue and earnings, the boost will be a one-time boost. Earnings for 2018–with those tax cuts–will show a significant improvement over earnings for 2107–without those tax reductions. But 2019 won’t show much, if any, gains on 2018 since the tax rate in 2019 will be what it was in 2018.
I view the Goldman Sachs “good as it gets” scenario through the lens of those 2018 tax-rate driven earnings improvements. Those better earnings for 2018 are likely to support investor sentiment and even push it higher from current levels for some part of 2018 as investors work those higher earnings into their forecast for individual companies and for the market as a whole. But at some point in late 2018 Wall Street analysts and strategists will begin looking far enough forward into 2019 to remove that 2017-2018 tax cut earnings growth from their forecasts. At that point they’ll start to ask, “So where’s the growth to come from above current levels?”
And that I think will mark a new significantly more dangerous time for financial markets.
Anybody who wants to control their downside risk needs to figure out when that turn in sentiment might start to show up.
After the May Fed meeting? After earnings reports for the June quarter get delivered in early July? Those seem significant potential turning points for me that could lead to a long sideways period for U.S. stocks or a correction.