There seems to be a narrative out there that the U.S. Federal Reserve is about to switch gears and pause because it acknowledged that capital spending growth has “moderated," but let’s not forget that the press statement carefully added that this moderation was coming off a “rapid pace."
Besides, business spending accounts for only 10 per cent of U.S. gross domestic product, while consumer spending is more than 70 per cent of GDP, and, on the latter, the Fed is convinced that this lion’s share of the economy continues to “grow strongly.”
The slowdown in capex growth – almost no growth at all in the third quarter and the monthly data are showing another flat performance for the fourth quarter – is more of a problem for all the supply-side economists advising the U.S. President who believe that tax cuts would spur on a business spending boom. That happened for two quarters and now is gone – the vast majority of the proceeds went to extending the share buyback boom.
That buyback boom seems set to fade in 2019 as some blue-chip firms are announcing a slowdown or stoppage in these programs, and some are doing the same for dividend polices too. Why is that the case? Because triple-B-rated companies, which have a massive US$3-trillion in debt outstanding, do not want to face a downgrade to junk and lose their institutional investor base.
What this means is smaller-return-of-capital policies for shareholders to support the bondholders.
Corporate deleveraging will be a key macro and market theme next year. The debt-heavy businesses facing a three-year tsunami of refinancings (US$2.5-trillion) will move to shore up their balance sheets by diverting cash flows toward debt-service repayment and, in some cases, debt retirement.
This alone will weigh against the prospect of any sustained capex boom, will depress economic growth and likely stay the Fed’s hands once it gets to the estimated 3 per cent neutral funds rate. And the failure of the S&P 500 share count to decline any further from its already depressed 18-year low will make it very challenging for a stock market in which consensus earnings-per-share growth forecasts for 2019 are still flirting near double-digit terrain.
The positive fallout from this is that we avoid a corporate debt crisis because the major rating agencies are expecting what I am talking about to actually take hold.
A reversion to the mean next year where companies switch their focus to protecting their debt investors by reining in the share buyback and dividend payout boom that emerged as such a defining theme during this elongated bull market in equities.
The theme for 2019 is one where the end of the share-buyback boom coincides with the end of the earnings boom, and that sets us up for, at best, a flat year for equities.
There are more downside than upside risks considering that all we know about next year with certainty, from a policy standpoint, is that everything the Fed has already done since the end of 2015 – let alone what it will do – will start to really be felt in 2019. And the fiscal stimulus withdrawal, with only gridlock now in the offing after the midterm election results, will also be a key feature for next year.
Let’s also keep in mind the inflationary impact, which cuts into real growth, from the trade war and from the spreading acceleration in wage growth – great for Main Street but a clear margin squeeze for Wall Street (Amazon.com Inc.’s 15 per cent pay hike kicked in on Nov. 1). Remember, the 10 per cent tariff already placed on US$200-billion Chinese-made goods was only implemented in September – we have not even seen the full impact hit home and there are threats of even more action ahead to consider.
The inflation or stagflation scenario will also put the Fed in a box, and the result will be that interest rates will not come down, or by as much, as typical given how bloated the fiscal deficit is and how stubborn inflation will be as well. The impact on margins from rising interest expense, accelerating wage growth, higher tariffs and the lagged impact of the strong U.S. dollar, will be considerable in the coming year.
And don’t forget the impact from a rapidly decelerating global economy – the leading indicator of the Organization for Economic Co-operation and Development is down for nine consecutive months, promising to deliver a synchronized global slowdown in 2019. The double hit from weaker growth overseas and the impact of a strong U.S. dollar will seriously affect the near 40 per cent of the S&P 500 companies whose revenues are booked from activity abroad. Without the crutch of the buyback cycle, it is not at all difficult to see a profits recession next year, even if we manage to avoid an “official” recession as determined by U.S. National Bureau of Economic Research.
So if there is an investment theme for those who manage equity books for a living, the acronym is QLDS — Quality, Liquidity, Defensiveness and Selectivity. Cull the portfolio and stick to your most high-conviction ideas.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.