Stocks are often said to climb a ‘wall of worry’ and in the US the ‘wall’ currently consists of investor concerns about rising interest rates, trade wars and the perception that the economic cycle is long in the tooth.
As the Federal Reserve has increased the cost of borrowing, we have seen some flattening of the yield curve – often a harbinger of recession. The potential onset of a fully-fledged trade war appears to have increased the dangers with president Donald Trump considering adding further tariffs on Chinese goods.
The longer these issues remain unresolved, the bigger the impact on business confidence and consumer spending. Some analysts anticipate we could see a number of multinational companies cite trade war issues as justification for reducing earnings guidance for the remainder of 2018. Given that the current economic cycle exceeds nine years (one of the longest in history), there certainly appears to be plenty to ‘worry’ about with the ‘wall’ looking pretty daunting.
Several positive factors should help stocks climb the ‘wall’, however.
Investors may be overlooking the reality that the economy is actually in great shape. US real GDP growth looks set to accelerate to over 3 per cent this year and even if the economy is ‘late cycle’ this stage can easily last two to four years so calls for a recession could be very premature.
A number of favourable indicators including inflation, housing and durables demand, consumer confidence, corporate and household leverage and corporate default rates suggest the cycle could actually be mid or even early.
One key measure of economic health, the ISM Manufacturing Index recently rose above 60 which is consistent with real GDP growth above 5 per cent. While company profit margins are at all-time highs, we have seen higher highs and lows since the 1990s reflecting the rebalancing of the economy towards businesses that require less capital and investment compared to prior periods.
Another underappreciated factor in our view is the strong possibility that stocks will be supported by better than expected earnings results for the second quarter.
Economists may be underestimating the amount of fiscal stimulus already in the pipeline and created by the Tax Cuts and Jobs Act. This should result in around $266bn and $446bn of stimulus in 2018 and 2019 respectively.
Yet since the passage of the bill, we have been surprised by how little Wall Street analysts have raised earnings estimates for US companies: operating income expectations are virtually unchanged. Thus far management teams have been upbeat on their guidance for second quarter reports with relatively few profit warnings given compared to companies raising expectations.
This impressive earnings backdrop should justify stock valuations and while PE ratios are at above average levels, ratings are far from the excessive levels we saw during the dot.com boom period of the late 1990s.
The current environment should be good for companies with niche products and services and large markets to attack.
During a recent research trip to Chicago we found several fitting this criteria including Stitch Fix, Inogen and Everbridge.
Stitch Fix’s online technology platform is transforming the way people buy clothes. New customers give specific details of their physical dimensions and style/brand preferences. Individual stylists then use Stitch Fix’s predictive algorithms to select merchandise with a high probability of matching what the customer would have bought when visiting a store. This business model appears to be having powerful results so far as customer loyalty levels are high. Clothes can be tried on at home and easily returned if necessary - a welcome option for those who find trips to stores time consuming and inconvenient.
Inogen makes portable oxygen concentrators (POCs) for people suffering from respiratory problems. The company is growing rapidly because POCs have become extremely popular. They allow patients freedom of movement as opposed to being tethered to cumbersome oxygen tanks. POCs are rechargeable and work by filtering air to remove nitrogen and carbon dioxide. They are also lightweight (similar in size to a small back pack) and hence versatile.
Everbridge protects citizens and corporate human capital by facilitating value-added information flow in life-threatening situations using text messages, e-mail, social media and iPhones. Its cloud-based software platform reduces emergency response times and saves lives when there are terrorist attacks or severe weather conditions.
Nick Ford is co-manager of the LF Miton US Opportunities fund. The views expressed above are his own and should not be taken as investment advice.