- Fidelity director of global macro Jurrien Timmer says valuations will continue to compress due to pressures from anti-trade policies and where we are in the economic cycle.
- If earnings growth stays in the 17-20% range moving forward, you can have what Timmer calls a “benign valuation reset” where valuations compress and stock prices go up.
- This is an important earnings season to watch as it is the first quarter since the corporate tax cuts. Timmer will be looking for companies to deliver the 17% earnings growth that is currently estimted. He will also be looking to see if companies guide higher or lower for the next quarter.
Jurrien Timmer is the director of global macro for Fidelity Investments. He stopped by Business Insider’s offices to talk to Sara Silverstein about his economic and market outlook. The following transcript has been edited for clarity.
Sara Silverstein:So just to start, what do you think about pressure on equity valuations at the levels that they are at right now?
Jurrien Timmer:Yeah, the way that I look at the world, you know, the market cycle has different phases and where we have been for the last few years has really been the Goldilocks, sort of mid-cycle phase. You know, decent growth, double-digit earnings growth, but no inflation, low interest rates, a Fed that’s sort of not getting in the way of things, and I think we’re now transitioning towards what we call late cycle. We’re not there yet, but we’re clearly moving in that direction. So the Fed is now in play, it’s raising rates, and typically that’s the part of the market cycle where valuations start to come down, and I think that’s especially relevant today because valuations have been so high. As of January at the recent high the trailing P/E was at 21 times earnings, which really gets up there, and so I think for the next year or so as we approach and enter late cycle, that’s really gonna be the big part of the conversation.
Silverstein:And how much do earnings have to continue to grow or grow in order to offset compression that we are seeing in valuations?
Timmer:Yeah, so that’s really the critical element because when you look at the market’s history, if P/Es need to come down, more often than not, that means the market comes down as well. But about a quarter of the time, you can have a P/E reset, if you will, while the market generally stays up. I know the market’s down 10% but statistically speaking that’s not a big deal historically. So the key component to that is how strong earnings growth is because when you look at valuation, it’s really the earnings go in the numerator of the discounted cash flow model and the interest rate or the liquidity environment goes in the denominator, and the stronger that earnings growth is in the numerator, the more the P/E can reset lower without knocking the market down, and that’s basically what we’re seeing. The forward P/E using next 12-month expected earnings has already declined from 19.4 in January to 16.1 at the recent low a few days ago. That’s a really constructive thing to happen while the market really is down, you know, 8% or 10%.
Silverstein:So not at the same scale.
Silverstein:And what are you looking at during this earning cycle to see if we will continue to be in that period where, like you say, we’re threading the needle in that sweet spot?
Timmer:Yeah, so it’s interesting because generally the earnings estimates, if you look at the aggregated consensus numbers, they tend to start high and drift lower. I mean, that’s sort of been a hallmark of earnings season. But this time around, this will be the first quarter since the corporate tax cut and the estimate is for a 17% year-over-year growth, and that estimate has been rock-solid now for probably at least four or five weeks. So it’s really interesting how it has not drifted down, and the same thing is true for Q2, which is pegged at 19% right now. So what I’m looking at for earnings season, which is of course starting now, is A: to see whether the companies will deliver that 17%, and my guess is that they are, because generally if they’re not going to, they will guide lower – you know, nobody likes surprises. But more importantly, will they guide towards the next quarter lower, the same, or higher? And again, the tax cuts were a really monumental event, a onetime event that a lot of companies weren’t even really expecting, and this will be the first quarter, post that tax cut. So it will be an important barometer to see where companies think they’re going, not so much in Q1 but moving forward. And if earnings growth stays up, you know, in the 17, 19, 20%, you can have what I would call a benign valuation reset. But if the numbers turn out to be either too high or they’re where they need to be but they will come down, then that maybe is a different story, cause then you lose that tailwind.
Silverstein:And when you look at the tech sector, does the same hold true as far as valuation pressures?
Timmer:For the tech sector I think it’s really about the earnings growth, because on a forward P/E basis, the tech sector only trades at 18 times earnings, and the market trades at, you know, 16, 17 times. So it’s really not that expensive. Price-to-sales is I think is at four times. Back in 2000 at the dot-com peak, it was seven times, so you know, so I don’t think it’s necessarily a valuation problem, but obviously it’s been a big momentum play. They have the earnings growth, and I think as long as that earnings growth continues, I think that sector will be ok the whole kind of growth – structural growth area, will be ok, but I think it comes down to the earnings. When you have very high earnings growth, you can support higher valuations, but even then we don’t really have such high valuations in tech.
Silverstein:And one of the other valuation pressures that you talk are the fears of a trade war or anti-trade policies. Can you talk about that?
Timmer:Yeah, so if globalization, which of course we’ve had since the early ’90s but especially in the 2000s, if the by-product of globalization is stronger global growth and lower inflation, then protectionism, I think is a form of deglobalization, and should bring the opposite.
If the by-product of globalization is stronger global growth and lower inflation, then protectionism, I think is a form of deglobalization, and should bring the opposite.
So it will bring less growth – still positive growth, but just less, more moderate growth, and probably somewhat higher inflation. And again, inflation and P/E ratios are very closely inversely correlated over time. And so if inflation goes up, the P/E should come down. So it’s another hallmark of late cycle. You got the Fed, you’ve got tariffs, potentially, protectionist trade policy, and both of those don’t necessarily have to knock the market down, but they are P/E negatives. They are headwinds for P/Es, and then it comes back to threading that needle of earnings offsetting the overall pressure on P/Es.
Silverstein:And the Fed tightening will be P/E negative. How worried are you about that, and how could it get to a place that becomes more dangerous for the market?
Timmer:Yeah, so last August which was a key inflection point for the market – because at that point, nobody was expecting tax cuts anymore and the 10-year Treasury had fallen to 2%, and the bond market which of course is always pricing in the potential future, was pricing in only one more rate hike over the subsequent two years. Which was kind of silly because the Fed, though its dots, was signalling six rate hikes in two years. So the market and the Fed were completely on different pages. Now they’re much closer, you know, as the market reset, because the tax cuts happened, the bond market and the Fed started to think about, “OK, we are getting fiscal stimulus nine years into an expansion at full employment, that has to be inflationary.” So now the market is pricing in about four more hikes in two years. The Fed is at five. So they’re still not on the same page but they’re very – they’re a lot closer. And so whether the 10-year Treasury belongs at 2.7 or 3.1, it’s close enough at this point. So for me to get worried about the Fed is if the Fed ends up being much more hawkish than what the market is expecting, driving that sort of risk-free rate higher. Then that would be another headwind, but at this point, there’s really no indications for that. And one way that I try to look at it, which is a little geeky but when you look at the real Fed funds rate, and you compare it what’s called the natural rate of interest, r* as it’s called. The real funds rate is around zero, and the natural rate is around zero, and historically the Fed has gotten the economy into trouble when the Fed was about two to three percentage points above r*. And we’re right on top of each other right now. So for me, even if the Fed were to tighten every quarter for the next two years, it would, we still kind of don’t get to that point where you really get worried about an inverted yield curve and the Fed kind of taking the punch bowl away too much. So I think for now, we’re ok here.
Silverstein:And how should investors be positioning themselves in this kind of “we’re ok and valuations could compress but …” Are you expecting any big downturns or are you just a little cautious with more volatility?
late cycle is a notoriously difficult part of the cycle to pin down, whereas midcycle is really the sweet spot.
Timmer:You know, the last two years until the January high, were really extraordinary times for the market, and I fear that investors got spoiled by that, because the S&P was up I think 52% in two years and in 2017 the volatility – the standard deviation of those returns – was at an all-time low of 3.9. And that created a Sharpe ratio, risk return divided by vol of five and a half, which is at the 99th percentile of all time, of the entire history. So it literally doesn’t get any better than that, and it’s not the way the market is normally supposed to be. You’re supposed to get 10% a year against a 15 vol, not 25 a year against a four vol. So I think as we transition from mid to late, volatility, of course it already has returned, but it will become a more volatile market, not unusually so, but consistent with history. And returns will be less, still positive but less. So it’s kind of a lower your expectations mindset, but it’s still a market that I want to be involved with because, but it’s just, it’s not a time to bet big, you know, late cycle is a notoriously difficult part of the cycle to pin down, whereas midcycle is really the sweet spot. And so you kind of rein in your bets, you lower your expectations but it’s by no means, in my opinion, a reason to get out.
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