«The upcoming earnings season should continue to remind investors that earnings have been greatly lifted by the tax cut.»
When Ed Yardeni speaks, investors listen carefully. The renowned investment strategist and President of Yardeni research has forty years of experience in the global financial markets and is highly regarded for his profound analysis when it comes to stocks, bonds, commodities and currencies. On Wall Street well known as Dr. Ed, he thinks equities still have more room to run albeit volatility is on the rise. “History shows that optimistic investment strategies tend to work better over time than pessimistic ones”, he writes in his popular new book “Predicting the Markets”. “Doomsdays occur from time to time, but they don’t last as long as the good times”, he adds during an interview. His optimism is based on the encouraging outlook for the global economy and on robust earnings growth in Corporate America. In fact, he thinks that the tax cuts will benefit US companies even more than investors expect.
Dr. Ed, since February investors have to cope with much more volatility in the financial markets. What happens next in the journey for US stocks?
I remain bullish. I’m expecting that the stock market will continue to move higher along with earnings. So far, I’ve counted 60 panic attacks in this bull market which started in March 2009. Four of those panic attacks were outright corrections of 10% but less than 20%. When the market took a new dive in early February I’ve said that it’s a flash crash and it’s not going to be something terrible. But you always have to keep in mind the possibility that one day we will have a panic attack that will actually turn into a severe bear market. That’s when you want to get out. But right now, I’m still in, since stocks are among the best investments in the long run.
What’s the foundation for your bullish outlook?
We had a significant melt-up in the market in January, largely because of the corporate tax cut. Since then we’ve had a lot of volatility because the good news on earnings was offset by concerns about a possible trade war and the realization that the Federal Reserve would continue to raise rates with the economy performing quite well. So we’ve had a tug of war between the bulls and the bears in February and in March. But as we get further into April, the upcoming earnings season should continue to remind investors that earnings have been greatly lifted by the tax cut. So I’m using a target of 3100 on the S&P 500 (SP500 2854.88 1.09%) by the end of this year and that’s because by that time the market will be looking at higher earnings.
The expectations of a big tax cut have pushed stocks higher for the most part of last year. Aren’t lower taxes already baked in at this level?
Congress passed the Tax Cut and Jobs Act at the end of last year. As a result, the expected growth rate in corporate earnings this year basically doubled from about 10 to almost 20%. It had a dramatic impact on earnings expectations. And of course, beyond that, earnings will grow back at their normal trend pace which is around 7%. During January when we had the corporate reports for the fourth quarter, company managements were very happy in announcing the impact of the tax cut on their earnings. But they didn’t know exactly how much of an impact it would have. In the first quarter announcements coming in April, they will give us specific numbers and I think they could turn out even better than the initial assumptions. So the earnings picture is great but that’s not just because of the tax cut by the way.
What else is fueling earnings growth?
The reality is that the global economy is doing very well. I know there have been some questions recently. But our data still shows that Europe is doing extremely well, Japan is doing better and the Emerging Markets are performing very well. We basically had a global growth recession in late 2014 and 2015 caused by the collapse in energy and other commodity prices. But those prices started to go back up in early 2016. Still, oil prices are much lower than they were in early 2014 when they were over a $100. Now, they’re more like $60 and that turned out to be a stimulus for the global economy. But probably the most significant cause of the revival of the global economic activity is kind of a déjà-vu: It’s similar to what happened in 2008/09 when China provided an enormous amount of stimulus. At that time, we saw a tremendous increase in Chinese bank lending and spending and that helped the global economy. Well, now they’re doing it again.
Also (ALSN 125.8 0.16%), the revival of the European economy took many by surprise. What’s your explanation for the economic springtime on the old continent?
Europe has been stimulated by the ongoing liquidity provided by the ECB. In addition to that, the migration flows from the Middle East and from Africa in 2014/15 might have actually turned out to be pretty stimulative. I know, there are concerns that those immigrants will bring in a lot of social tensions and maybe even some terrorism. But history shows that mass migrations tend to be very stimulative for economies. So that may also be accounting for the strength in Europe.
That sounds quite upbeat. But is there anything investors should keep an eye on in terms of risks?
Inflation really is important. I think it’s dead which is a strong statement and I may turn out to regret it. But if I’m wrong about anything I hate to be wrong about inflation. Because if inflation does come back we will see a completely different environment for investors. Interest rates will go up and bond yields will go up and stock markets will take a dive. But I don’t see that at this point.
Why is inflation so dangerous?
Inflation is actually much more important than recessions in the business cycle. Recessions come and go and when they occur they’re awful and everybody gets very pessimistic. But history shows they don’t last very long. In contrast to that, inflation tends to persist: either it goes up for a long time or it stays low for a long time. My work suggests that inflation tends to be a war time phenomenon and when you have peacetime the result is globalization.
What do war and peace have to do with inflation?
During peace times national markets get more integrated and as a result there is more competition on a global basis. So global competition together with technological innovation and aging demographics is a real inflation killer.
But then again, it sure looks like US President Trump is focusing more on protectionist measures which could push the United State into a trade war with China.
This whole situation reminds me of the concept of the bond vigilantes back in the early eighties. Bond vigilantes are bond market investors around the world who protest monetary or fiscal policies they consider as inflationary by selling bonds. So they sort of act as the law and order in financial markets. As a matter of fact, Bill Clinton when he was President was very cognizant of the bond vigilantes. Today, in a similar way the tariffs President Trump intends to slap on certain imports might be the incipient formation of the Dow Vigilantes.
What do you mean by that?
The bears could make a comeback if President Trump turns into an outright protectionist. But it’s more likely that he will back off if the market continues to react badly to his protectionist pronouncements. After all, he clearly prefers the Dow Jones (Dow Jones 25962.51 0.84%) as a measure of his popularity over opinion polls. So here’s the Dow Vigilantes idea: It’s the idea that financial markets have a tremendous influence on policy makers and the Dow Vigilantes have made very clear that on any move towards a trade war the markets are going to take a dive. The policy makers seem to get the message pretty quickly. Just look what happened towards the end of March when the market sold off dramatically on all this trade war talk. On that Sunday, the administration seems to have responded to the Dow Vigilantes by having Treasury Secretary Steven Mnuchin on the Sunday TV shows saying: “Hey, we’re already making progress on these trade issues. We’re not going to have a trade war, we’re going to have trade deals.” After that the markets had an amazing week. Something similar happened again this week.
Nevertheless, it seems like that Wall Street’s honeymoon with Trump is coming to an end.
Trump huffs and puffs and he threatens to blow everybody’s house down. But at the end of the day he’s a deal maker. He’s not a warmonger. He doesn’t want to make war, he wants to make deals. Ever since President Trump was elected I said that you don’t want to underestimate him. He’s got a lot of personality issues that people are not fond of. He’s definitely an unusual president who tweets a lot and has a habit of listening to advisers and then firing them and then hiring somebody else. But so far, I’m impressed by the fact that unlike most politicians he’s actually making good on his promises. Again, you may not like his promises but from an investor’s standpoint it’s not about good or bad. It’s about bullish or bearish and so far, Trump’s policies have been very bullish for the stock market: Deregulation is a big positive for companies and so are corporate tax cuts.
However, central banks around the globe seem to be determined to normalize monetary policy. Can the financial markets really handle that after all those years of ultra-low interest rates and abundant liquidity?
Many central bankers just still don’t understand that inflation really is more of a microeconomic phenomenon than a macroeconomic phenomenon. They still believe that inflation is totally determined by central bank monetary policy. But that has been proven completely wrong by the facts. What’s important for investors is that as long as inflation stays down we don’t have to worry much about the central banks raising interest rates aggressively to the point of causing a recession to bring inflation down.
In the US, the Federal Reserve has already made a lot of progress in terms of policy normalization. How far can the Fed go?
We may very well continue to have a low inflation environment with economic activity improving and showing that it’s more sustainable. In that environment, the Fed is likely to normalize monetary policy. It’s not normal to have interest rates this low. So the Fed seems more attuned to what the economy is doing and they’ve taken this opportunity to normalize. When I say normalize, I mean they’re aiming to get the Federal Funds Rate by the end of next year to about 3%. So the question is: if inflation stays low and they continue to normalize might we still have a financial crisis because we got used to interest rates being so low? History does show that what often happens during booms is that interest rates are too low and when inflation makes a comeback central banks start to raise interest rates, and something breaks. I don’t see that scenario right now. But I have to admit that when we look back to the financial crisis it surprised us and there were only a few people that recognized the subprime mortgage problem.
And what about other important central banks?
The ECB and the BoJ need to open up their eyes and start to follow the Fed. Certainly, negative interest rates in Europe and in Japan make no sense in this environment. So they should sooner rather than later normalize their policies because it’s time for interest rates to reflect a more normal global economy. I think it’s doable and it will also moderate the pace of asset appreciation and keep asset prices going up along with earnings which is what we want to see. We don’t want to see asset prices going into a melt-up situation which is what we saw in January in the US stock market.
So what’s your advice for investors right now?
At this point, clearly nothing is cheap. You look around the world and you’re not going to find that assets prices are extraordinary bargains. That’s why you have to invest for earnings growth. The outlook for the global economy is pretty bright. In school, I was taught that economics is about allocating scarce resources. But that’s too pessimistic. Economics is actually about recognizing how technological innovation creates abundance: Shortages lead to higher prices and higher prices create tremendous incentives to innovate technologically and replace the goods or services that are in shortage with something that’s in abundance. So I’m very excited about that since technology is evolving faster than ever.
What does this mean when it comes to portfolio allocation?
As an investor, whether you’re in Switzerland, in Europe generally or in Japan or in the United States or in India, you just want to have a diversified global portfolio: Emerging Markets, Europe, the United States. Just bet that the global economy is not going to fall into a recession. There will be some corrections along the way but be optimistic. Being bullish has paid off for the past forty years of my career and it will pay off for the next forty years.
And where do you spot the most attractive opportunities?
Nothing jumps out at this time. Technology looks great, but it got overvalued and now we’re seeing some corrections going on in the FANG stocks and in some other areas. If you want to get alpha, you have to focus on small stocks. But there is also a lot of risk there. So again, if you’re an investor who doesn’t have the time to spend all day doing research the best thing to do is to put 35% of your money in the US, 35% in Europe, 10% in Japan and 20% in Emerging Markets.