Increased expectations of central bank easing (Fed, ECB, Bank of Japan)
The threat of a trade war increases the risk of a decline in growth and, as a result, S&P500 company earnings could deteriorate significantly following their robust outcome in 2018. Note that, to date, bottom-up consensus estimate revisions to S&P500 EPS growth have been minor. We use a simple top-down macro EPS model (real GDP growth, core CPI, oil and US Treasury yields) to identify earnings growth under different scenarios. Any escalation in a trade war could reduce EPS to a range of 2% - 8% depending on cumulative goods tariffs and the associated effect on activity.
Currently, bottom-up consensus estimates for S&P500 earnings per share point to an annual growth rate of +2% in 2019 and +11% in 2020. Top-line (revenue) growth is projected at close to 6% in both years, in line with the 2001-2018 average. This would leave profit margins elevated at circa 12% in 2019/2020. As the economic cycle matures, margins face pressures from rising wages and higher input costs which are directly and indirectly affected by current and prospective tariff changes. Indeed, escalating trade tensions risk a slowdown in economic growth through higher imports costs and higher uncertainty, lower investment and consumption, supply chains disruption effects, hence threatening corporate earnings prospects. However, the likelihood of severe margin contraction (i.e. above 100bps) is low without a recession.
In a scenario of a 25% tariff on all US imports from China, US real GDP growth could fall by 0.2 pps - 0.3 pps and core inflation could increase by up to 0.5 pps assuming a 50% pass-through based on third party estimates. EPS would decline by circa 2-5%. In a more adverse scenario of 25% tariffs on all imports (worth circa $885bn) from China and Mexico (although an agreement was reached between the US and Mexico on Friday), EPS could be hit harder -- by more than 8% -- with real GDP growth being hit by circa 0.4 pps and core CPI up by 0.9 pps, assuming a 50% pass-through on third party estimates.
While markets expect the Fed to cut rates for the first time in a decade to support the economy amid elevated trade and political uncertainty, history shows that when the Fed cuts rates in a decelerating growth environment (e.g. 2007), equity markets tend to perform poorly. On the other hand, when the Fed eases, even as economic activity remains resilient (1995, 1998), equity prices perform strongly. As a result, the Fed should be pro-active rather than reactive. In that context, June and July FOMC meetings are expected to shed additional light on the Fed’s strategy.
The ECB was more dovish than expected, extending its forward guidance to “the first half of 2020” compared with end-2019 previously. Importantly, the ECB deemed not significant any possible side-effects on the banking sector from negative rates. This could leave the door open for additional cuts in the future, while the same might be true for other instruments (e.g. asset purchases) in the event the euro area faces renewed adverse contingencies (see Economics for ECB Macro Projections). Importantly, the ECB announced a tad slightly less favorable rates for the new TLTRO series (compared with TLTRO2) that equals the Deposit Facility Rate plus 10 bps if eligible net lending towards corporates and households, excluding mortgages, exceeds a benchmark rate, and otherwise the MRO rate plus 10 bps. Officials will likely review TLTRO pricing.