Authored by Michael Wilson, chief US equity strategist at Morgan Stanley
Will the US Consumer Hold Up?
In the first quarter, the popular narrative people used to explain and justify the sharp rally in stocks was that the global economy was bottoming and would reaccelerate in the second half of the year. That story rested on hopes for more fiscal stimulus from China, a resilient US economy that still had legs from the tax cuts and robust corporate profits that would lead to more capital spending, hiring and wage growth for the consumer.
We disagreed with that narrative, suggesting that the global economy would likely not bottom in 1Q as China did less than expected on the fiscal front and the US economy came under pressure from weaker US corporate profits. We argued that corporate profits would disappoint and therefore so would capital spending and eventually other corporate activity affecting the economy, including hiring and wage increases.
Fast forward to today, and it’s safe to say that the global economy has disappointed most expectations this year, even ours, and it hasn’t just been China weakness. With 70% of PMIs around the world now below 50, we haven’t seen negative breadth like this since the global financial crisis. The UK, Singapore, Hong Kong, Japan and Germany are very close to a recession already. That’s a good chunk of the global economy. Meanwhile, US corporate profits and capital spending have disappointed this year, too. Despite these twin headwinds, the US economy remains okay. US GDP has been slower than expected for the first half of the year, but still growing at a respectable 2%, thanks to a resilient US consumer.
Since last October, I’ve been steadfast in my call for a US profits recession this year and skeptical of the big second half recovery that company management teams promised back in the first quarter. With second quarter earnings season throwing cold water on a second half recovery in profits growth, S&P 500 3Q EPS expectations are now down to -2.7%, well below the -0.5% growth in the first half of the year. For the S&P 600 and 400 (small- and mid-capitalization companies), the third quarter EPS forecasts are even weaker, at -7.4% y/y, worse than the -5% y/y growth seen in 1H19. By the way, the estimate for 3Q19 was +10% a year ago. Most importantly, 4Q19 and 2020 estimates still look way too high and far above the normal “overestimate” that bulls argue is always the case. In particular, the positive operating leverage baked into current consensus estimates seems fantastical to me.
An even broader measure of US corporate profits, the National Income and Products Account (NIPA), shows the same trends as the S&P small and mid-caps. This matters because the bullish narrative today is that while the US industrial/manufacturing part of the economy is weak, the US consumer remains strong, so the US economy can avoid a further slowdown or recession. Though that may be true for now, this profit trend is unequivocally bad, and getting worse. Such a broad profits recession, if it doesn’t get better soon, is exactly what could lead to layoffs. Obviously, such an outcome would negatively affect the US consumer and is really all that separates the US economy from a recessionary outcome. On that score, we’re already seeing companies take action on labor by reducing the number of hours worked and hiring at a much slower pace than last year.
While it’s not yet clear whether layoffs are coming, the risk is elevated, and it’s unlikely that the third quarter earnings season will bring much comfort, given the newly enacted tariffs that kick in this week. Therefore, I continue to expect further downside in US equity markets this quarter and believe that the S&P 500 will trade to 2700. Stay defensively oriented in portfolios – overweight utilities and staples – and be careful with expensive secular growth stocks that aren’t priced for a potentially weaker labor market and higher risk of recession.
Enjoy your Sunday.