2019: The Year Of Higher Stocks & Lower Yields

Treasury bonds are in an extremely strong rally as inflation and growth expectations come down. I like to compare this situation to 2016 which is the last slowdown. In the summer of 2016, the 10-year yield hit its lowest level in history. It’s interesting that yields bottomed in the summer because the economy troughed a few months earlier. In the reverse situation, yields topped in November 2018 even though the economy had been slowing for a few months. I’m not saying to expect Treasury yields to keep falling after growth bottoms, but with the decline in nominal GDP growth still going, it’s possible yields fall further.

One of the most curious aspects of markets in 2019 is how stocks have rallied and bond yields have fallen. You can say bonds have recently taken charge because stocks have followed yields lower during this August correction. Because the treasury curve is flatter now than in 2016, the 30-year yield is the closest to hitting a new record low. Its record low was 2.0882% in July 2016. Even though the treasury market has seen growth slowing this year, investors may have flocked to American stocks because it has been one of the top-performing economies. The analogy most often used is the American economy is the cleanest shirt in the dirty laundry pile that is the weak global economy.

Lower Yields Good For Stocks?

Those who believe lower yields encourage investors to take more risk look correct this year because stocks have risen during a slowdown while yields have fallen. Personally, I think stocks rose in 2019 because they got too cheap late last year. There was sharp multiple compression in 2018.

It’s notable how stocks fell in late 2018 as yields rose. The big change from late 2018 to early 2019 is the Fed got much more dovish. The Fed doesn’t want to admit it, but it’s probably in a cutting cycle. Going from the end of a tightening cycle to the start of a cutting cycle is a huge change. I have previously discussed how it’s not set in stone how many rate cuts count as the start of a cut cycle. With rates being so close to zero, many are saying just 2 cuts count as the start of a cut cycle. If that’s the case, then we are in one because the Fed will cut for the 2nd time in September.

Getting back into the discussion of whether lower yields are good for stocks, my mindset is lower yields help bond-like stocks. If a stock has a high dividend yield like those in the utilities or consumer staples sectors, then bond investors might consider it. I don’t see treasury buyers dipping their toe into risky stocks like Beyond Meat just because yields are low. The decline in treasury yields has been a boon for these stocks. I remember in 2016 when many of the consumer staples stocks reached bubble levels. High PE ratios for firms with declining earnings in a rising yield environment is a recipe for disaster.

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As you can see from the chart below, 55% of stocks have dividend yields above the 10-year yield which is near a record high. This percentage will only increase as stocks and yields fall. I don’t necessarily think this makes high dividend stocks a screaming buy. It just explains why utilities have done well while the ‘risk-on’ trade for stocks has been in place. These firms are very overbought just like treasuries. On the opposite side, energy stocks have underperformed because these firms like when inflation rises as it usually implies oil prices are increasing.

Q2 Earnings Season Update

The relative performance of Q2 earnings season depends on which metrics you review. As you can see from the chart below, the most important performance metric, which is the change in next quarter’s estimates, shows this earnings season improved from the last one. This is based on 451 firms in the S&P 500 reporting results. Q3 estimates have fallen 1.67% as a result of this quarter. Estimates almost always fall, so don’t be alarmed by the decline.

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As you can see, this is the best performance since Q3 2018 as estimates have fallen at a slower rate for the past 2 quarters. The Q3 2019 estimate decline is slightly worse than the 3 year average of -1.39%. The 3-year average is manipulated higher by the tax cut. Besides periods where recessions are just ending, estimates rarely increase. Without the tax cut, the 2.55% positive revision would have never happened. Taking those 2 quarters out makes this quarter look even closer to average. This positive revision trend goes directly against the narrative that this is an earnings recession which is only going to get worse in the future.

As you can see from the table below, on an absolute basis EPS growth will get back on track in Q4 2019 if results come close to current estimates. Q4 estimates will probably fall slightly below 5% by the time Q4 earnings season starts, but with the beats that usually occur factored in, growth should be in the mid to high single digits. The earnings growth slowdown will be over if the economy doesn’t weaken further. To the bears, that’s obviously a major assumption.

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Tariffs Matter More

According to FactSet, the number of S&P 500 firms mentioning tariffs on their conference calls has exploded in Q2 which makes perfect sense given the latest news on the trade war with China. Specifically, in Q1 88 firms mentioned tariffs and in Q2 124 firms mentioned them. That’s still below Q2 2018 when 162 firms mentioned them. Back in Q2 2018, tariffs were a curiosity; now they are a reality.

Industrials firms mentioned tariffs the most as you can see from the chart below. The biggest increases in the number of mentions from Q1 were in tech and financials which went from 6 and 1 mention to 17 and 7 mentions. Regardless of the number of mentions, the impact of the trade war in Q3 2019 will be the greatest of this cycle unless a deal is made soon.  

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