Last week, the U.S. Federal Reserve (the Fed) hiked by another quarter point to 2.0-2.25% as expected. The dot plot indicates one more hike in 2018 and three hikes in 2019. To us, there are a few signs that the Fed is getting close to the neutral rate: 1) the Fed dropped the “accommodative” language in the FOMC statement; 2) the 10y-2y Treasury yield spread is already under 25 basis points (bps); 3) the long-term federal funds target rate estimate is now 3.0%, below the 3.75% & 3.5% estimates at 2014 & 2015 end. The latest dot plot suggests the Fed will reach 3% at 2019 year-end. If the neutral federal funds rate is below 3% for this cycle, then the yield curve will likely go flat. A flat curve isn’t a big worry, it just means that the long-term bond market thinks the federal funds rate is above what’s needed to contain inflation. If inflation stays contained at about 2% then the Fed will be able to cut rates on the first sign of any economic slowing. Ending a hiking cycle by cutting rates upon slowing, but without a recession soon following is a classic soft landing. This has occurred: 1966, 1985, 1995. We think this likely occurs again in late 2019 or early 2020 and that this expansion continues well into the 2020s.
Normally the cost of equity (CoE) is 300-400bps above Treasury yields, i.e. the equity risk premium (ERP). The S&P ERP is usually 200-250bps above investment grade (IG) credit spreads. This suggests that the nominal CoE should be 6.5% when the cost of long-term corporate debt is 4.25%. Large S&P firms of solid IG status can borrow for 10 years at 4.25% or 125bp over Treasury yields right now vs. 130bps average the last 30 years. This suggests a 2.25% real cost of debt if inflation is 2%. This plus a 200-250bps premium suggests a real cost of equity of ~4.5% for large S&P firms of solid IG status, which supports a 22 S&P PE on steady-state S&P EPS.
But, in our view, real borrowing rates will rise slowly along with higher Treasury Inflation Protected Securities (TIPS) yields as the Fed hikes rates through 2019. And we expect the S&P ERP to stay larger than normal vs. IG credit spreads as Fed hiking continues. Also, the ~25% S&P EPS growth in 2018 should slow to 5-7% in 2019 and beyond. To value the S&P 500, we use a 3.5% long-term Treasury yield plus a 400bps ERP (same as 1.5% investment grade (IG) credit spread plus 2.5% incremental risk premium), i.e. 7.5% nominal cost of equity or 5.5% real. This translates to an 18 price-to-earnings ratio (PE) on normal S&P EPS. At 18.6x our 2018E EPS, the S&P is trading at a 5.4% offered real CoE, slightly richer than our fair value estimate.
Strong S&P rally in the last two years squeezed the premium of S&P implied ERP vs. U.S. long-term IG credit spread by ~100bps from 4% to 3%. But it’s still higher than the 2.2% average since 1987. Equities are more attractive to us than fixed income. We overweight equities and underweight fixed income with 63% and 32% allocations respectively. Within equities our CIO view is neutral on regions and sectors globally, but Emerging Markets (EM) Asia likely to offer the best returns in the next 12 months.
U.S. corporate spreads at both investment grade and high yield (HY) remain very tight (IG 125bps and HY 350bps). The bond market suggests that U.S. corporates can and have fared well around federal funds rate normalization. Under the new tax law, companies can use repatriated cash to retire some of their debt while also being able to boost dividend and buyback payouts. Currently, HY credit spread is only 215bps higher than IG credit spread, at low levels only touched several times in the last three decades: 1997, 2007, and 2014. We think the outperformance of HY over IG has run its course and the trend is likely to reverse in the next 12 months. We lowered high yield corporate credit allocation from 5% to 4% last week.
3Q earnings season reporting will start in two weeks. We expect S&P to deliver another quarter of 20%+ strong earnings-per-share (EPS) growth. But we think companies’ comments and estimates on trade conflict impact will be much more cautionary especially for 2019 EPS despite having basically dismissed any material profit impact from tariff during 2Q reporting. We think the current ~$180 consensus 2019 S&P EPS is too high. Normally S&P’s next calendar year consensus EPS starts to get cut when the current calendar year is over, but this year the cuts might happen earlier given the new development on trade conflict. Other things to watch include signs of margin pressure, capital expenditure (capex) guidance and foreign exchange (FX) comments.