The U.S. economy and stock market have been on a tear. But corporate profits may not be able to keep up, Morgan Stanley Wealth Management’s Lisa Shalett warned.
“In fact, we see expectations for corporate profits may have gotten ahead of what is achievable, especially as the economy approaches full employment,” Shalett said.
Sure, the fundamentals alone paint a rosy picture of the current U.S. economic landscape. Real gross domestic product jumped 4.2% in the second quarter of 2018. Unemployment clocked in at 3.7% for September – its lowest level since December 1969 – after hovering at an already-low rate of 3.9% for five months. Average hourly wages advanced 3.3% at an annual rate over the last six months, marking the fastest pace of this cycle.
And to top it all off, Federal Reserve Chairman Jerome Powell assured listeners during a speech last week at the National Association for Business Economics that “higher wage growth alone need not be inflationary,” staving off some concern that the tightening labor market may lead to price increases.
But the very factors pushing the economy to its current fever pitch may be simultaneously putting corporate profits under pressure, Shalett argued. Specifically, she warned the burden of rising wages, higher oil prices, increased funding costs, a stronger dollar and fallout from tariffs and trade tensions will ultimately fall to companies.
“Effective portfolio strategy at this juncture requires acknowledging that market and earnings peaks may differ materially from economic peaks as investors anticipate inflection points,” Shalett said.
A stock market harbinger
Headwinds to profits are already starting to show through in company earnings guidance.
“While the Fed and interest rates are pivotal, earnings trends are also a critical indicator because
their rollover signals the point at which incremental growth can only be achieved at lower margins, as the costs of an economy at full employment and utilization become apparent,” Shalett said.
“Early validation of such concerns may be seen in the ratio of negative-to-positive third-quarter corporate earnings guidance, which has jumped to more than 8:1, the highest level since 2011,” she observed.
And this disappointing third-quarter earnings guidance could well be a “harbinger” for the current white-hot U.S. economy. which Shalett says “is in the process of peaking.”
“Current economic conditions are among the best they have been this cycle, but this is not the time for complacency. Markets trade according to expectations and in anticipation of turning points, often topping out well in advance of a peak in economic activity,” she added. “When it comes to market and business cycles, too much of a good thing is often bad, as frothy activity levels counterintuitively pull forward a downturn and set up a more severe correction.”
Shalett’s comments echo the bearish sentiments of Michael Wilson, Morgan Stanley’s chief U.S. equity strategist, who viewed last week’s equity pullback as a sign that “portfolios need to shift.”
“Still solid economic data and a Fed that continues to tighten is continuing to push both nominal and real yields in the U.S. higher, bringing end of cycle risks into focus, capping equity market valuations, and leading to intra-market rotations on a sector and style basis,” Wilson wrote in a note.
With these factors in mind, Shalett offers a piece of investment advice: “Consider trimming US equity winners in tech and consumer discretionary sectors while adding to energy, industrials, staples, telecom and utilities.”