A new Capital Economics report projects that U.S. mid-cap and large cap-stocks will flirt with bear market territory as their “relentless outperformance” ends and markets slip 16.4 per cent by the end of the year.
Published on Thursday in response to this week’s 25-basis point interest rate cut announced by the U.S. Federal Reserve, the report predicts markets will turn once investors realize that forecasts for corporate earnings in the U.S. and the length of the Fed’s rate cutting cycle are too optimistic.
In a scenario that may give investors deja-vu about the end of 2018, Capital Economics senior economist Oliver Jones, who co-wrote the report, said over the next four months disappointed investors will initiate a selloff of momentum stocks, and it will become “contagious” once it surpasses 10 per cent. In 2020, however, the pattern will stabilize and begin to recover, just as it did in early 2019, when investors realize they’ve oversold.
Jones used the MSCI USA Index, which is made up of more than 600 mid- and large-cap stocks, as a reference in the study and suggested that end-of-year losses will result in it gaining only 1.9 per cent in 2019. It’s up 21.9 per cent year-to-date.
“When you get a sharp fall in the market like that, the most cyclical sectors that have done the best on the way up tend to be the hardest hit,” Jones said. “That would be the pattern we’d expect and a reversal of that when the recovery begins.”
The U.S. markets see-sawed on the Fed’s interest rate cut on Wednesday, plunging initially but recovering substantially to finish the day positively after Chairman Jerome Powell’s press conference explaining the move. What’s most troubling for Jones is that despite the move to cut rates again, the Federal Open Market Committee is divided over the next steps. Five of the 12 FOMC members supported holding rates instead of cutting them on Wednesday.
Already, Jones said, the pattern is beginning to diverge from the initial expectations of investors pre-emptively pricing about six rate cuts in to the market. Jones sees only one more cut, occurring in December, and — critically — no cuts taking place in 2020 when the markets still expect the cycle to continue.
You don’t have to believe a recession is around the corner to think the forecasts of strong earnings growth over the next couple of years just don’t look realistic
Oliver Jones, senior economist, Capital Economics
“Markets were banking on the Fed to cut aggressively to give the economy a big shot in the arm for next year and that’s unlikely to happen because it’s treading a bit more cautiously,” he said.
Investors will also be disappointed to see a slowing in earnings-per-share growth in the stocks that have been leading the market’s upswing. The outperformance of these names has been driven by their EPS growth, Jones said, which has swelled considerably in comparison to some of their global competitors.
Part of the reason might be because they’re inflated, Jones said. Multiple firms engaging in share buyback programs see their EPS numbers artificially inflated because a repurchase lowers the number of outstanding shares. Undertaking this strategy is one way multinational companies have learned to “flatter their accounts and report their earnings in a way that looks particularly favourable.”
EPS growth is still projected to continue to grow at the average rates, which Jones said is unlikely given that the global economy is growing at its slowest pace since the financial crisis and that the U.S.-China trade war will act as a drag on those numbers as well.
“You don’t have to believe a recession is around the corner to think the forecasts of strong earnings growth over the next couple of years just don’t look realistic,” Jones said.