Week of October 14, 2019
Current economic events
The economic slowdown continued last week, with numbers from around the world starting to depict a global economy in which data levels, no longer just trends, are becoming concerning. Global surveys from Sentix showed investors’ opinions of the current state of the economy at its lowest since February 2016 and closing in on the worst since 2009. Additionally, the developed world composite leading indicator from the Organization of Economic Cooperation and Developed (OECD) pointed to continued weakness ahead, at its lowest point since 2009. The Organization said it expected continued easing growth momentum in the United States, eurozone and Japan over the next six to nine months. While a recession is not our base case, risks are rising, with data nearing its lows of previous mid-cycle slowdowns and only trace indications of a bottoming underway.
Potential help from policymakers is ongoing and volatile. Chinese Vice Premier Liu met with President Trump in Washington on Friday for high level trade talks. A negotiated “phase one” deal that cancels scheduled tariff hikes and reportedly contains other provisions, ranging from intellectual property protections and agricultural goods purchases, emerged from the talks. Notably, the deal is not yet laid out in writing. In other policy news, the Federal Reserve’s (Fed) September meeting minutes showed members pushing back on market expectations for rate cuts, which current pricing gives 50/50 odds of 0.5 percent in rate cuts by year end and more than a 95 percent chance of at least one 0.25 percent cut. Fed Chairman Jerome Powell assessed the economy as “in a good place” in a Tuesday speech. With global fiscal stimulus tapering down, the catalysts to unlock more than a “muddle-through” global economic environment in coming quarters appear limited.
U.S. economic data was uninspiring last week. The most highly anticipated report, consumer price inflation (CPI), missed estimates — both headline and core inflation ticked lower. Core and headline producer inflation (PPI) also fell. The Job Openings and Labor Turnover Survey (JOLTS) disappointed, with job openings contracting more quickly year-over-year, hiring growth contracting and open jobs to unemployed ratio falling. The National Federation of Independent Business Owners' optimism index fell and is contracting at its fastest year over-year-pace since prior economic slowdowns in 2012 and 2016. Sentix’s U.S. survey depicted a rapidly weakening current situation, with its headline index dropping into negative territory for the first time since October 2012. A lone bright spot came from the University of Michigan’s consumer sentiment survey, which showed optimism rising in October. While U.S. economic momentum appears to be stabilizing, trends remain negative for the 12th straight month.
Data released in Japan showed its economy slowing to new cyclical lows. Japan’s leading economic indicator dropped precipitously in August ahead of its October 1 sales tax hike, with its year-over-year growth rate dropping to its worst since 2009. The Economy Watchers survey expectations fell to the lowest point since the month before Japan’s last tax hike in 2014, which led to a recession. New orders of machine tools contracted sharply since last year, just off May levels that were the fastest contraction since 2009. A severe contraction in core machine orders also pointed to slowing capital expenditures in the economy while producer prices deflated at their fastest rate since late-2016. While growth in personal consumption expenditures (PCE) picked up slightly in August, it was likely attributable to government stimulus ahead of the tax hike aimed at holding up consumer confidence. Eurozone data was not much better; its Sentix survey depicted near-recessionary conditions, with the headline index falling to its worst level since mid-2013. Spanish consumer confidence plunged to five-year lows. Industrial production contractions worsened in France, Italy and the United Kingdom (U.K.), and German trade and industrial data was also weak. U.K. gross domestic product (GDP) monthly estimates showed the economy contracting in August, though likely avoiding a technical recession in the third quarter. Our proprietary foreign developed country Health Check shows these economies deteriorating to the worst point since November 2014.
U.S. equities rallied last week following three consecutive weeks of price declines over rising optimism of a United States/China trade agreement. Corporate earnings are apt to dominate headlines over the next four weeks, with 85 percent of S&P 500 companies slated to release third quarter results during that time. Forward guidance and the extent to which tariffs are impacting economic growth will be watched closely. Equity prices continue to inch higher as the pace of earnings growth wanes, which is a longer-term disconnect. Restrained inflation, low interest rates and a lack of widespread euphoria for equities are among reasons supportive of our risk-on (aggressive) bias.
The performance of U.S. equities remains resilient, superb and broad-based. The S&P 500 has largely been a “buy the dip” market throughout the year, repeatedly rallying past obstacles, including lingering trade tensions, an inverted yield curve, impeachment discussions, ongoing geopolitical risks and global economic slowing. As of Friday’s close, the S&P 500 is up 18.5 percent for the year, with all 11 sectors posting positive returns, nine of which are up 13 percent or greater. The Information Technology sectors continues to lead overall performance, advancing 31.6 percent year-to-date. The S&P 500 is a mere 1.8 percent shy of the all-time high, which is 3,025 reached on July 26.
Third quarter earnings releases are set to ramp this week, with 10 percent of S&P 500 companies scheduled to release results, led by money center banks. Forward guidance and, to a large degree, results and guidance from the Information Technology sector are apt to be primarily drivers of equity prices into year-end and 2020. Of near-term concern is the slowing pace of earnings growth. Consensus earnings estimates for the S&P 500 for 2019 are roughly $165 per share, about 4 percent above year-ago levels but with a downward bias. The S&P 500 currently trades at approximately 19 times trailing 12-month earnings and 17.5 times estimated forward earnings. This is short of extremes and a generally compelling level, given the low inflation, low interest environment — as long as earnings hold up. However, expectations for third quarter earnings continue to be reset lower. Earnings are currently estimated to decline 4.8 percent over year-ago levels, according to FactSet Research Systems, reflecting low expectations but, arguably, setting the stage for upside surprises. Energy and Information Technology are projected to have the greatest year-over-year decline in earnings, retreating 37 percent and 10 percent, respectively, according to FactSet. The declining expectations for the Information Technology sector is perhaps most noteworthy, since the sector represents roughly 22 percent of the market capitalization of the S&P 500 and is the best-performing sector year-to-date. Advancing prices at a time when earnings are being reset lower is a disconnect, a trend that is unstainable over time. To be determined from third quarter results and forward guidance is whether sub-industries of the Information Technology sector, such as software versus hardware and equipment, have notable growth and outlook differences. As such, to a large extent, it’s likely that as the Information Technology goes, so goes the performance of the S&P 500.
Our published year-end 2019 price target for the S&P 500 is 3,135, based on a multiple of 19 times earnings of $165 per share, and toward the upper end of our low-high price target range of 2,805-3,300.
Fixed income markets
Treasury yields rose steadily last week, following perceived progress in trade talks with China. The rise in yields was led by long-term bonds as beaten-down economic growth and inflation expectations disappointed. The yield curve steepened, with 10-year Treasury yields moving above three-month yields for the first time in months. Fed minutes from the September meeting highlighted diverse expectations for the path of the funds' rate. We expect the Fed to cut interest rates again at the end of October, which the market is pricing as a 75 percent likelihood. We expect continued interest rate volatility as the views of the Fed and the market consolidate. Heightened yield volatility and our bias toward somewhat higher interest rates inform our recommendation that investors hold a slight duration underweight to reduce interest rate sensitivity.
The Fed announced a plan to purchase up to $60 billion in Treasury bills per month starting mid-October, at least into the second quarter of 2020. The purpose is to alleviate disruptions in short-term borrowing markets that started in mid-September. Fed Chairman Powell made it clear this should be viewed solely as a technical adjustment rather than another round of quantitative easing aimed to loosen monetary policy.
Corporate credit spreads tightened last week on the back of improved investor sentiment. U.S. investment-grade and high yield corporate credit valuations are slightly expensive compared to 15-year historical medians but have been supported by strong fund flows. Bank loans have consistently underperformed high yield bonds since we noted rising risks in November 2018. Weak investor protections (covenants) should result in larger credit losses than historical cycles. Issuance and flows have been extremely weak as investors have become more skeptical of the category. We suggest investors maintain portfolios comprised primarily of high-quality debt to diversify equity holdings.
Defensive sectors trailed the broader market last week after apparent progress in United States/China trade talks, which resulted in a “risk-on” rally. Infrastructure was the best-performing sector, finishing the week in line with the broader market. The Utilities sector was the worst performer, with 2 percent underperformance versus the S&P 500. In real estate-related news, it appears Softbank will continue to extend additional cash to WeWork, the largest office tenant in many major markets. This cash probably helps WeWork fund operations for a little while longer, but the business needs to become more efficient, meaning less growth. WeWork currently has $47 billion in long-term lease obligations (future costs) outstanding. Offsetting that is $4 billion in leases from tenants (future revenue). The company has a long way to go to attain profitability. We believe that the rationalization of the WeWork business model will have implications for the office market nationally.
Crude oil prices, as represented by West Texas Intermediate (WTI), rose 3.5 percent last week, with all the gains coming on Friday, when progress on the trade deal was achieved. For the year, WTI is up more than 20 percent. Domestic fundamentals were slightly negative for prices, with small increases in domestic crude inventories and production levels hitting a new all-time high. Global growth concerns are currently in control of market prices. However, Middle East turmoil can move the market significantly in an instant.
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