Heightened volatility in interest rates, U.S. dollar (USD) and West Texas Intermediate (WTI)/Brent crude-oil prices are the main drivers in the near corrections of the S&P 500 since September end. First, 10-year U.S. Treasury yields jumped from 2.8% to 3.25% on falling-unemployment-related inflation fears; if yields exceed 3.5%, a fair S&P price-to-earnings (P/E) ratio is likely under 18. Then a stronger USD vs. Chinese yuan (CNY), euro (EUR) and pound sterling (GBP) from U.S.-China trade tensions, Italy-EU fiscal tensions and Brexit. Then, oil prices swooned on supply as producers overly prepared for Iran sanctions, causing wider credit spreads and the S&P to test its October lows.
Despite the recently heightened volatility, all three have managed to stay within a range supportive of the economy and equities, in our view. Treasury yields retreating from recent highs and slowing their ascent relieves some U.S. housing risk. The Trade-Weighted U.S. Dollar Index stayed below 100, posing a manageable headwind to S&P earnings-per-share (EPS) growth. While current oil prices threaten our 2019E Energy profits, at $55-65/bbl WTI and $60-70/bbl Brent oil will keep Energy profits stable and at the upper part of the range to deliver about 10% EPS growth in 2019. We believe global economic growth will slow in 2019 and we expect S&P 500 EPS growth to slow too; likely to about 5% in 2019 from 25% in 2018. But we remain confident that S&P EPS will be up in 2019 and above $170. As growth slows in the U.S. and abroad, we think the 10-year Treasury yield stays well below 3.5% and the U.S. Federal Reserve (Fed) slows its hikes.
High-yield (HY) credit spreads spiked to above 800 basis points (bps) during the plunge in oil prices back in 2015-2016. The oil-price decline since early October is nowhere near the severity of 2015-2016 and companies have improved their ability to operate profitably at lower oil prices since then. Yet in recent weeks, HY credit spreads widened from 360 to over 400bps as $55/bbl oil will pressure balance sheets at many smaller energy firms. We do not consider this widening of credit spreads to be systemic, nor a lead indicator of deteriorating macro conditions. We disagree that credit is a lead indicator in this regard, we see credit as simply reacting to commodity markets and view this credit risk as contained to commodity producers. We think WTI oil is likely to be well supported at $55/bbl and should average $60-65/bbl in 2019. Most S&P 500 companies are investment-grade-rated, only 11% of issues are rated BB+ or below, whereas 84% of the Russell 2000 with a credit rating is junk-rated. Albeit most small companies do not have credit ratings; they rely more on bank debt. S&P 500 leverage has gone up since 2015, but it's still at low levels compared to history. But Russell 2000 net debt / EBITDA (earnings before interest, tax, depreciation and amortization) is at rather elevated levels.
We expect the Fed to hike again in December. Four hikes this year is fine, given that inflation climbed from below to be more solidly at the Fed's 2% target. But we have long argued that inflation is likely to get stuck at around 2% for the rest of this cycle. We think the consumer price index (CPI) is peaking and likely to soften. But regardless, we focus on labor-market conditions, not oil prices. Average hourly earnings should continue to grind upward on rising productivity. Productivity-driven wage growth is not inflation. It is prosperity! Unit labor costs have and should remain stable at about 2%. At the same time, we expect real gross-domestic-product (GDP) growth in the U.S. and around the globe to slow in coming years. Europe and Japan are still far from raising their benchmark interest rates. The Fed should feel less urgency to hike overnight rates after 2018.
Value stocks outperformed during the S&P's near-correction, but this is attributable to Defensive Value, as Cyclical Value and Cyclical Growth performed similarly. However, we don't expect Value to outperform Growth in the medium to long term. The valuation premium of Growth vs. Value is not rich: Russell 1000 Growth ex FANG is trading at a 16% premium vs. Russell 1000 Value ex Financials, which is slightly below the historic average of 19%, while the EPS growth of R1000 Growth ex FANG is 23% vs. 18% for Value ex Financials. We continue to prefer Growth over Value.