Current economic events
Week of December 9, 2019
Last week included the most market volatility we’ve seen since October, but U.S. stocks still posted gains when a positive November jobs report and late-week trade optimism outweighed concerns from earlier in the week. Markets were initially rocked by the Institute of Supply Management (ISM) manufacturing purchasing manager’s index (PMI) report, which heightened worries that the ongoing contraction in the manufacturing sector may not be subsiding. Trade issues also continued to ramp up, with President Trump twice surprising markets. On Monday, the President unveiled his plan to restore steel and aluminum tariffs on Argentina and Brazil, arguing that the Latin American nations have purposely devalued their currencies at the expense of U.S. agricultural exporters. The next day, the Office of the Trade Representative said it is looking into tariffs on European products and President Trump said a trade deal with China may not be made until after the 2020 election. This roiled markets that have rallied based in part on easing trade tensions. However, the tougher talk was walked back by other Administration members later in the week, and China waived tariffs for some U.S. soybeans and pork on Friday. The White House is still scheduled to implement tariffs on December 15, though the market expects these will be delayed as pursuit of a “phase one” deal continues. A breakdown in talks and subsequent implementation of December tariffs is likely the greatest near-term risk to markets.
Global data continued to be biased optimistically, despite continued lagging in key developed nations. Global Markit (PMIs) in both the manufacturing and services sectors improved in November as the composite indicator reached a four-month high. Much of the boost came from China, where the Markit composite PMI rose sharply to its strongest point since February 2018. The strength was echoed by official Chinese PMIs, which also rose to multi-month highs. Consumer confidence among developed nations in the Organization for Economic Cooperation and Development (OECD) fell by the least since May while confidence in the U.S. rose for the first time since May. Our proprietary global economic “Health Check” is at a seven-month high, although remains in a modest downtrend.
U.S. economic data was generally stronger last week, and jobs data especially impressed. The economy added 266,000 jobs in November and the unemployment rate fell to 3.5 percent, matching the lowest level in 50 years. Though some of the increase was a result of General Motors strikers coming back to work, the number was still surprisingly strong, with year-over-year growth in payrolls improving. Wage growth and the labor force participation rate ticked down, but both remain near their strongest levels of the cycle. Consumer sentiment from the University of Michigan rose to among its strongest levels since 2000. PMIs diverged, with ISM readings falling in both manufacturing and services and Markit readings rising in each sector. Core capital goods orders continued to contract during the month, though the pace of decline eased slightly. Trade data continues to lag, with both exports and imports posting the largest contractions since 2016 in the October Balance of Payments report. Our U.S. economic Health Check has reached a four-month high, and economic momentum has turned the most positive since May 2017.
Foreign developed economies have not yet joined the United States and emerging markets in reaccelerating. November composite PMIs were mixed, picking up during the month in Japan while the United Kingdom (U.K.) and Australia dropped and the eurozone was flat. PMIs remain indicative of contraction in Japan, the U.K. and Australia, while the eurozone is marginally positive. European data pointed toward a continued slowdown in the fourth quarter, with October eurozone retail sales growth dropping to a three-month low and German industrial production contracting at its fastest pace since late 2009. Our foreign developed economic Health Check has fallen to its lowest level since November 2014 and remains in a downtrend for the 20th straight month.
The fundamental and sentiment backdrops remain positive for U.S. equities, supportive of a risk-on (aggressive) bias heading into 2020, while technical price trends appear less conclusive. Clearly, momentum is strong, enhanced by last Friday’s strength on the heels of a favorable employment report. There seems to be limited or no resistance to higher prices, considering that the S&P 500 is at all-time highs. Conversely, all-time highs imply that the broad market may be somewhat overbought, resulting in a narrow margin of error and indicating that new allocations may be arguably better spent on market pullbacks. Uncertainty surrounding Federal Reserve (Fed) policy, United States/China trade negotiations, holiday spending levels and the pace of earnings growth are among reasons that pullbacks seem inevitable.
The fundamental backdrop is bolstered by restrained inflation, low interest rates and a dovish Fed, plus moderate earnings growth. Additionally, fixed income remains a relatively unattractive alternative, with roughly 50 percent of S&P 500 companies having dividends that yield above the 10-year Treasury yield of approximately 1.8 percent.
Sentiment is also favorable. Performance year-to-date has been resilient, superb and broad-based. Valuations, elevated but at neither high nor low extremes, are reasonable given the low interest rate environment. The S&P 500 is up 25.5 percent year-to-date as of December 6 and 16.7 percent over the past 12 months. All 11 S&P 500 sectors are positive in 2019, and 10 of 11 are up over the past 12-month period. The Energy sector continues to be the worst-performing sector, negatively impacted by the slow pace of global growth and relatively high crude oil inventories versus demand. Information Technology continues to provide performance leadership, bolstered by software and its association with artificial intelligence and machine learning. Valuations are creeping higher while still trending below extremes. The S&P 500 is trading at roughly 19.0 times forward 12-month earnings estimates, above the 30-year average of 17.1 times. As long as earnings hold, valuations remain within a “zone of okay,” shy of the 20-plus times forward earnings estimates that are more often associated with valuation extremes.
The technical outlook is less conclusive, supporting the notion that U.S. equities are priced-to-perfection with a narrow margin of error. Technical price trends reflect strong momentum, with the S&P 500 trending essentially at all-time highs of 3,153 reached on November 27. Strong momentum at all-time highs implies minimal technical resistance, paving the way for prices to grind still higher. However, the S&P 500 is roughly 3.4 percent above its 50-day moving average, 5 percent above its 100-day moving average and 7.1 percent above its 200-day moving average. Over the past two years, the S&P 500 has rallied above and down to the 100- day moving average nine times, providing historical precedence that the current gap between price and 100- day moving average may eventually narrow.
Our published year-end 2019 price target for the S&P 500 is 3,135, fractionally below current levels. Our single-point year-end 2020 price target is 3,325 (19 times earnings of $175 per share), approximately 6 percent above current levels and near the mid-point of our price target range of 2,975 to 3,500.
Fixed income markets
The U.S. Treasury curve steepened (yields of longer-term bonds rose more compared to shorter-term bonds) alongside other foreign sovereign curves last week as economic data beat expectations and hopes of a trade deal gained traction. Investors lowered expectations of a Fed rate cut next year after a strong jobs report Friday and a surprise drop in the unemployment rate. We expect the Fed will make no change to the current policy rate at this week’s meeting. The “dot plot,” which displays Fed members’ outlooks on the path of monetary policy, is likely to indicate consensus is for no changes to the current rate through 2020. We recommend investors in taxable bonds favor a portfolio with slightly below-benchmark duration due to a strong labor market, rising inflation expectations and stabilizing economic data, combined with limited yield pick-up available when extending to longer-term bonds. Investors in tax-free municipal bonds should take advantage of the steeper municipal curve and resulting yield pickup from longer-maturity options and maintain a slightly above-benchmark portfolio duration. Municipal bonds still offer attractive tax-adjusted yields relative to corporates and Treasuries for investors in higher tax brackets, despite relatively high valuations.
U.S. credit spreads (corporate bond yields compared to Treasuries) narrowed from already tight levels last week following improving investor sentiment and a strong jobs report. Demand for extra yield drove investment-grade credit spreads to a new 52-week low and high yield credit spreads near their 52-week low. Strong demand for U.S. corporate credit has the potential to keep spreads rangebound and below long-term median levels, despite broadly weakening credit fundamentals. High corporate indebtedness has yet to squeeze companies or bond investors due to healthy margins, strong cash flow generation and low interest rates. When these factors reverse, higher leverage will likely become more problematic. We continue to suggest investors hold primarily high-quality bonds in their portfolios to provide adequate diversification against stocks.
Defensive sectors traded essentially flat last week, in line with the broader market. For the year, all the defensive sectors have underperformed the S&P 500. Real Estate was the laggard last week, finishing with underperformance of 0.4 percent versus the broader market. We see the defensive sectors as fully valued and with decelerating growth. It will be hard for these stocks to outperform unless interest rates move to lower levels.
Crude oil prices, as represented by West Texas Intermediate, were up 7.5 percent last week after the Organization of Petroleum Exporting Countries (OPEC) cut an additional 500,000 barrels per day from its planned production quota. OPEC is now maintaining cuts of 1.7 million barrels a day from its planned production. This trims about 1.7 percent from the expected global production of liquid fuels, according to estimates from the U.S. Energy Information Administration. OPEC believes the additional production cuts will be enough to prevent the market from becoming over supplied. The rise in oil prices was accompanied by a rise in energy stocks, which outperformed the S&P 500 by 1.7 percent last week. However, this is relatively inconsequential when considering that the energy sector has underperformed the S&P 500 by 20 percent over the past year. While energy stocks appear cheap, we do not yet see catalysts to resolve this significant underperformance.
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This information represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated or associated with any organizations mentioned.
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