Buy Bonds?

Macro Perspectives

---

We kicked off Q3 earnings season Friday with the big banks.

These earnings reports come from a period during which the economy was hot, growing at about a 5% annualized quarterly growth rate. Yet, FactSet shows Wall Street estimates are still looking for a 0.3% decline in S&P 500 earnings.

That sets up for positive surprises, which tends to be good for stocks . . . and we're seeing it early on, in the reporting from three of the big four banks. All three beat on earnings and revenues. The average year-over-year growth for JPM, Wells Fargo and Citi was 18% earnings growth on 13% revenue growth.

These are big tech-like growth numbers, but trading at an average valuation of just 8 times earnings (trailing P/E) - that's less than half the market P/E.

And remember, all of the big banks have spent most of the past three years manufacturing down earnings, by setting aside billions of dollars in allowances for loan losses. Yet when the risk of loan loss rises, they've been backstopped by the Fed (de-risked) and incentivized to fuel credit creation to help the economy - from which they make money in loan origination, investment banking and trading.

When times are more stable, their customer account balances balloon, from which they get to earn an interest rate spread from the rising interest rate environment.

The big banks continue to prove (thanks to policymaker manipulation) that they are "heads they win, tails they win" businesses.

With all of the above in mind, the contraction in S&P 500 earnings, of the past several quarters, should be behind us. The analyst community's consensus on Q4 earnings is expected to be 7.6% growth (yoy). For next year (full year), they are looking for a return to double-digit earnings growth (12% growth, yoy).

With that outlook, the bottom-up target price for the S&P 500 over the next twelve months is 5,115 - 17% higher than yesterday's close.

Additionally, both the market and Fed are projecting lower yields by this time next year, to the tune of more than 50 basis points - that means bonds are a buy. 

So, this brings us back to my note from last month on the 60/40 portfolio (Wall Street's trusty 60% equities/40% bond allocation). The portfolio finished down 18% last year with both stocks and bonds contributing to the negative return. Something that's only happened four times since 1928.

Each of those four times in history (1931, 1941, 1969 and 2018), bonds finished up the following year (total return). This time, with two and a half months remaining in the year, bond investors are still down (ytd).

UBS had a note out yesterday saying they think stocks, bonds and cash will produce positive returns through the middle of next year. The backdrop we've discussed above would align with that view.

What would global war look like for these two key asset classes? Below are returns when wartime spending kicked in, during World War 2 . . .

• Stocks averaged 25% a year.

• Bonds averaged 2.8%.

On the latter, remember, the Fed capped interest rates at low levels (yield curve control) to finance war debt.

ps: If you know someone that may benefit from reading my notes, please share this with them.