Mother’s milk

RYANBy Guest Blogger Ryan Lewenza

Larry Kudlow, Trump’s key economic advisor, and one of the more reasonable economic minds in his administration, is famous for saying “profits are the mother’s milk of stock prices”. Meaning, where profits go, generally goes the stock market.

This can be seen in the chart below which overlays the S&P 500 with the index’s earnings going back decades. This simple but important chart captures the strong relationship between stock prices and earnings over the long run. Further hitting home this point is the fact that, since the 1950s, earnings growth for the S&P 500 has averaged 7.5% annually, which is roughly the average yearly price return of the S&P 500. We can slice the data a number of ways and it all comes back to the fact that earnings drive stock prices over the long run.

So what’s happening with corporate profits?

Where Earnings Go, Stocks Go

Source: Bloomberg, Turner Investments

In short, they are on fire!

Following the earnings recession of 2015-16, S&P 500 earnings have surged hitting new all-time highs in the process. S&P 500 Y/Y earnings growth has averaged 16% since 2017 with Q1/18 earnings growing at an impressive 20%, marking the strongest earnings growth rate since 2011.

This quarter analysts are projecting earnings to rise 17% Y/Y, however, given the recent historical beat rate of 4% (earnings have beaten analyst’s estimates by 4%), I see earnings growing at roughly 20% Y/Y again this quarter. This is incredible and is very supportive to stock prices.

The strong earnings growth is being driven by a combination of robust revenue growth (7-8% over the last few quarters), continued high margins, stock buybacks and a lower corporate tax rate following last year’s historic US tax reform.

Strong Earnings Growth Expected for Q2/18

Source: Bloomberg, Turner Investments

A common talking point among analysts and the media is that earnings are going to peak soon and that this will be the final nail in the coffin for this bull market. This has been the most hated bull market in history with one excuse after another supporting an imminent bear market sell-off. To cite just a few: end of Fed’s QE policies, high valuations, record debt levels, Trump, trade war, Brexit, Greece, etc. We agree that earnings are of course going to peak, as nothing lasts forever, but we see this as more of a 2019 or 2020 story.

One reason I believe this trend of strong earnings can continue is because of what we are seeing with analyst’s earnings revisions. Typically, analysts start out with high expectations at the beginning of the year then revise them lower over the year. You can see this typical pattern in the chart below. This year we saw the opposite with S&P 500 earnings being revised significantly higher from US$148/share at the beginning of the year to US$159/share currently. The positive earnings revisions reflect stronger US and global growth and the much lower corporate tax rate for this year.

Typically Estimates Are Revised Lower – Not This Year!

Source: Bloomberg, Turner Investments

Right now we’re getting bombarded with lots of headline risk, much of it emanating out of 1600 Pennsylvania Ave. So during these hectic periods it’s critically important to refocus on the fundamentals. The US and global economy remain strong right now and corporate profits are hitting new all-time highs. If Trump can get out of the way with his escalating trade war (and save himself), stocks should continue to gain in the second half of the year on these robust corporate profits.

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.

The fly

Poor savers. Interest rates have jumped four times in Canada, yet the needle hasn’t budged much for high-interest accounts or those brain-dead GICs. Mortgages cost more. Lines of credit are higher. Credit cards, business loans and consumer borrowings are all dearer, and yet people sitting on cash have seen their wealth wither.

That continues.

The inflation rate, we heard Friday, is now 2.5%, the biggest number in six years. Gas, food, clothing and accommodation all cost more. If the burgeoning trade war gets out of control, US-imposed tariffs will jump the inflation rate further. We can only guess what your next Harley will set you back.

So here’s the point: banks want spreads. That gap between what they pay on deposits and the interest they collect on loans is called profit. It can never be too wide, and these days savers have absolutely no clout. Nobody cares.

By the way, here are the best high-interest savings accounts rate in Canada, as compiled by the nerds at RateSpy:

Notice that none of these offerings equals the inflation rate. Put money in any, and you lose. Of course, outside of a TFSA, all interest earned is 100% taxed at your marginal rate. That means an even bigger loss for savers. Besides, that 2% teaser at the National Bank is temporary, while Alterna Bank is the go-to lender for weed companies – which seem to be wildly overvalued. Sigh. So many conservative, risk-averse people pushed into such a shadowy embrace.

So is there any relief on horizon for those misguided souls who think that avoiding stocks, bonds, trusts, ETFs, funds, preferreds and every other marketable asset means no risk? Can anyone reasonably expect to build a retirement portfolio by stuffing their cash into only interest-bearing investments? No, and no.

Now, Friday’s numbers did raise the odds of a further Bank of Canada increase in October – adding another quarter point to the cost of a variable-rate mortgage and home equity lines of credit. Plus economists expect a couple more in 2019, even with trade wars on the horizon.

But there is a yuge fly in the ointment when it comes to the potential course of monetary policy. This week, fresh off embarrassing himself on the world stage with his Putin-poodle routine, Donald Trump lashed out at the US Federal Reserve, saying he opposes further interest rate increases. They boost the dollar, he argues (correctly), which makes American exports more expensive and less competitive. Higher rates also restrict consumer spending, which accounts for over 70% of the economy. And since Trump’s all about growth, expansion and inflation, higher rates are bad. Furthermore, the guy is adding boodles to the national debt with his corporate tax cut, so Fed hikes just make it more expensive to service that debt. That money could be sued instead to employ hubcap workers in Flint.

Thus, he hates ‘em.

What can Trump do about the Fed other than Twittering it into submission?

Quite a bit, as it turns out. Currently there are three Fed governors and four vacancies. Of the three, two are Trump appointees. Two more are Trump guys waiting for Senate confirmation. After that he can nominate two more – and end up with six of the seven decision-makers in his pocket. Interest rate decisions are made by the Fed’s Open Market Committee, which has 12 seats, the majority of which may soon be Trumpers.

Of course, the Fed was always designed to be fully independent from government, acting (like the Bank of Canada) to set monetary policy in the best interests of the wider economy, and not the leader or the party in power. Throughout history, this has mostly been the case, with presidents (and prime ministers) doing little more than bitching about bank decisions after they were made.

But this prez is different. Unlike all those who went before, he knows everything. Immigration policy. Foreign relations, Military strategy. Fiscal planning. Entertainment biz. Budgeting. And, of course, monetary policy. The odds of him at least trying to take over the Fed seem formidable. The consequences could be incredible.

The Fed’s main role – after saving the economy from the black hole of 2009 – is to corral inflation so things don’t run too hot. Without higher rates, it’s argued, the US will go into an inflationary wage-price spiral weakening the dollar and, if accompanied by highly protectionist policies, propeling America into a growth orgy. In other words, just what the president wants. Debts will get easier to pay, taxes can stay low and incomes jump. For a while – until the piper plays.

But that will be for the kids to worry about. The Donald will be gone.

So if you think the stock market’s rich now, just wait. And may God have mercy on your high-interest savings account.