Week of February 17, 2020
Current economic events
The S&P 500 rose to all-time highs last week as receding concerns about the spread of the coronavirus outbreak (the current strain is now named COVID-19) boosted global markets. U.S. economic trends showed continued improvement, as did global sentiment and leading economic data. However, initial indications showed the impact of the coronavirus on China’s economy and its trade partners may be substantial in the near term. A few data points, including Chinese car sales and Hong Kong tourism, fell precipitously in January as consumer quarantines dented activity. Even so, there has generally been little indication yet in the data about the total extent of the economic damage. The market is looking past the short-term weakness to the benefits of the growing stimulus from the Chinese government and the slowing rate of growth in the outbreak. Pre-virus data also continues to improve worldwide, with our proprietary global Health Check, a statistical measure of the average health of current economic data, reaching a 13-month high.
The U.S. economy appears to be accelerating, but with some divergence in sector performances. Elevated confidence levels among consumer and small businesses in February support our positive view, despite a slowdown in January consumer spending. The manufacturing sector continues to contract, but leading indicators point to a speedy recovery. While job opening numbers were quite soft, other labor data show a tightening market that should help support consumer spending. On the other hand, housing data is likely to slow from its recent strength as the benefits of falling rates in 2019 ease. Consumer inflation also reached its highest level in more than a year, helped by prior gains in crude oil prices. Our U.S. Health Check has improved sharply over the past few months, due in large part to stabilization in the manufacturing and service sectors, reaching its best level since March.
Despite improvement in sentiment, we have not yet seen hard data to confirm a pickup in foreign developed economies. Business and investor confidence numbers are improving in the eurozone, Japan and Australia. However, key manufacturing data points in the eurozone and Japan that are also indicative of global growth prospects continued to disappoint in December and January. Our foreign developed Health Check is just slightly off multi-year lows, with no material acceleration showing up in cyclical sectors, like manufacturing, thus far.
Restrained inflation, a dovish Federal Reserve (Fed), modest earnings growth and relatively uninspiring alternatives provide valuation support and the basis for stocks to trend still higher. We believe the primary driver of higher equity prices in 2020 is likely to be both modest multiple expansion (higher price-earnings ratios) and earnings growth. This differs from 2019, when the predominant source of upside was multiple expansion. Clearly, uncertainty surrounding the coronavirus is clouding the visibility of company earnings and placing downward pressure on the pace of estimated earnings growth in 2020. Coronavirus-related uncertainty is also likely to keep central banks in an accommodative stance for the foreseeable future. Slightly higher multiples on tempered, yet still rising, earnings imply higher stock prices.
Year-to-date performance leadership of U.S. equities is mixed and narrow, impacted by coronavirus-related fears. Information Technology, Utilities and Real Estate are leading performance; Energy and Materials are lagging, consistent with the continued slow global growth trends.
Fourth quarter sales and earnings are trending modestly above low expectations, with the Utilities, Communication Services and Healthcare sectors posting the highest year-over-year earnings gain. Energy and Materials lag. With roughly 80 percent of S&P 500 companies having released results, according to Bloomberg, sales are up 3.6 percent, above the estimates for a 2.3 percent increase. Earnings are up 1.3 percent, above expectations for a 1.7 percent decline over year-ago levels.
Consensus earnings estimates for 2020 seem overly optimistic and subject to downward revision as coronavirus-related economic slowing gets factored into consensus estimates, perhaps beginning after quarter releases in April. Consensus estimates are for S&P 500 earnings of approximately $175 per share in 2020, roughly 10 percent above 2019 levels. At present, perhaps as many as one-third of S&P 500 companies say COVID-19 is impacting near-term results; however, few are quantifying the effects. We expect estimates for 2020 to trend lower following first quarter results as visibility into the impact the virus is having on company profitability improves.
Technical price trends indicate equities are modestly overbought, implying U.S. equities are priced-to-perfection with a narrow margin of error. The S&P 500 begins this week trading at 3.8 percent, 7.5 percent and 11.5 percent above 50-, 100- and 200-day moving averages, respectively. Our published single-point year-end 2020 price target for the S&P 500 is 3,400, fractionally above current levels, with upside to the 3,570 level. We intend to revisit our assumptions and price target as first quarter results and forward guidance are released, beginning in mid-April.
Fixed income markets
Bond yields were relatively stable last week in response to ongoing uncertainty around the impact of the coronavirus on the global economy. Treasury yields and corporate credit spreads (corporate bond yields compared to Treasuries) remain near multi-year lows. Fed Chairman Jerome Powell testified before Congress last week, echoing the Fed’s outlook from its January meeting. The Fed plans to hold rates steady if economic data remains generally aligned with the expectations, though Powell acknowledged the possibility of rate cuts down the road considering COVID-19 uncertainties. For the time being, market speculation of one to two rate cuts this year appear premature. Our expectation for subdued bond returns (driven by low yields and tight spreads) and improving economic data contribute to our preference for stocks over bonds.
Corporate bond spreads held tight last week, which we view as consistent with broadly improving economic data. High demand for yield, cheap financing costs and strong corporate cash flow are all supporting credit spreads at levels tighter than historical norms. Nonetheless, we recommend investors hold primarily high-quality bonds with near-benchmark duration exposure within fixed income allocations. Corporate leverage continues to increase and exposure to high-quality bonds helps ensure adequate portfolio diversification. Ample duration is especially important (not just short-term bonds), given our underweight recommendation toward bonds in favor of U.S. equities. We continue to look for return opportunities in areas like structured credit and emerging market bonds.
Defensive sectors of the market (Real Estate, Infrastructure and Utilities) traded better than the S&P 500 last week as fears about the coronavirus declined and interest rates remained near the bottom of the recent range. Real Estate was best among defensive sectors, gaining almost 3 percent versus the S&P 500. Infrastructure was the laggard, with flat performance compared to the broader market. Real Estate and Utilities are now outperforming the broader market for the year so far and trade at levels never achieved before. Infrastructure trades slightly below highs attained just prior to the great financial crisis. Although we see these sectors of the market as fully valued, they provide an attractive investment option if interest rates remain low. However, a move higher in interest rates could result in severe price declines.
Commodities were finally able to stage a rally last week, with oil and copper ending a long string of declines. The crude oil market rose 3.5 percent last week, but is still down almost 15 percent for the year. The increase came despite domestic fundamentals that were negative for prices. Domestic crude inventories rose significantly, with only a small decline in refined product inventory, and production rose slightly to all-time highs. In addition, global oil demand estimates for 2020 were revised lower by the International Energy Agency, the U.S. Energy Administration and the Organization of the Petroleum Exporting Countries (OPEC). With a well-supplied oil market, it appears price potential is skewed to the downside, unless global growth concerns abate and OPEC agrees to larger production cuts.
Industrial metals and precious metals also staged small rallies last week. Copper, a bellwether for the global economy, rose 2 percent and the broader industrial metals market rose 1 percent. Like oil, price potential appears limited, unless global growth concerns ease further. In the precious metals market, gold was up 1 percent, even with improving sentiment in the broader market. Given the uncertainty around the coronavirus, low global interest rates, ample liquidity from central banks and a high level of negative yielding debt globally, there is plenty of price support for precious metals.
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