Week of May 20, 2019
Current economic events
As has so often been the case recently, geopolitics and economic data drove global markets last week. Posturing on United States/China trade, the United States getting tough on Chinese chipmaker Huawei, the White House delaying tariffs on imported autos and heightened U.S. tensions with Iran all grabbed headlines last week. This occurred during a mostly risk-off week, despite May survey data coming in upbeat. Amid all this news was data from the Organization of Economic Cooperation and Development (OECD), whose April leading indicators showed the United States, China and the developed world at their respective weakest points since 2009 and poised for strongly below-trend growth over the next few quarters. The numbers especially stood out because the U.S. economy has only survived this level of weakness in its OECD leading indicator twice since 1955 without falling into recession. The indicator successfully predicted recessions nine times in that period. Consensus appears to be coming around to this view, with the average economist forecasting a substantial deceleration in U.S. growth over the next year, though not a recession.
In the United States, especially, it appears that April showers (poor data) may be leading to May flowers (stronger data). Beginning with the former, a host of hard data showed continued weakness in April. Most prominent was industrial production growth, which has begun to flirt with stagnation. Poor headline and core retail sales growth, lower capacity utilization and continued contraction in housing supply also did not inspire confidence. Jumping forward to May, we’ve seen nearly all the survey data showing better results, including Friday’s preliminary consumer confidence reading from the University of Michigan, which had its best reading since 2004. In addition, regional Federal Reserve (Fed) manufacturing surveys from the New York and Philadelphia Feds showed sharp improvements, boding well for the heavily watched Institute of Supply Management (ISM) purchasing manager’s index (PMI). The same was true of the National Association of Home Builders (NAHB) housing market index, which reached its best level since October, and the Centre for European Economic Research (ZEW) survey, which showed the current economic situation in the United States improving the most since October. Despite the strength we’ve seen in May surveys, we still see the U.S. economy near its weakest point in two-and-a-half years, with strong downtrends and a weak economic impulse.
A similar data situation may be unfolding in the eurozone, where April hard data continues to disappoint while May surveys are a bit better. April industrial production growth weakened in the eurozone, falling back into contraction after a month of expansion, while May’s ZEW current situation survey improved in the eurozone and Japan. Developed foreign economies appear to be past their worst point but have struggled to build momentum so far this year.
While still depicting below-trend growth in many emerging economies, OECD composite leading indicators were flat or improved in every major emerging market in April, despite weakening in each major developed market. With this backdrop of recovery, Chinese April hard data were quite disappointing. Industrial production growth dropped to its worst rate since 2008, retail sales growth fell to its lowest level since 2003 and fixed investment growth slowed. While there may have been some remaining seasonality involved from the timing of China’s Lunar New Year holiday, these numbers do not support a Chinese economy trying to find a bottom, especially since all the weak data came before the reintroduction of trade tensions a few weeks ago. Meanwhile, Russian gross domestic product (GDP) growth dropped to its lowest rate since December 2017, with the commodity-dependent economy responding to a lower oil price during the quarter. Even though recent hard data has disappointed, we increasingly see trends stabilizing in many emerging economies, though not yet recovering as quickly as hoped.
U.S. equities traded mostly off last week, with United States/China trade tensions lingering and first quarter releases winding down. Despite recent headwinds, we continue to maintain a risk-on bias for U.S. equities, bolstered by non-problematic inflation, low interest rates, stable credit spreads and moderate earnings growth. In the absence of a near-term trade resolution and in anticipation of the impact that the trade impasse is having on global commerce and overall company profitability, it is plausible that U.S. equities will trend generally sideways into midyear and the release of second quarter results beginning in July. Our published year-end 2019 price target for the S&P 500 is 2,970, roughly 4 percent above Friday’s close of 2,859.
The first quarter reporting period is rapidly coming to a close, with 92 percent of S&P 500 companies having released results as of May 17. By most metrics, first quarter results are in line with or above expectations, according to Bloomberg.
- Sales are tracking in line with estimates while earnings are trending approximately 6 percent higher.
- For the quarter, sales are up 4.5 percent over year-ago levels and earnings are up a more modest 1.4 percent.
- Eight of 11 S&P 500 sectors are posting positive year-over-year earnings growth, led by the 13.5 percent gain of the Communication Services sector and 10.8 percent gain of Consumer Discretionary.
- Information Technology, Energy and Materials are the three sectors posting negative year-over-year earnings growth, which is consistent with slow global economic growth and lingering trade tensions.
Technical price momentum appears pressured, though not broken, with the S&P 500 trading below its 50-day moving average but above 100- and 200-day moving average levels.
- Periods of consolidation are within the normal ebb and flow of daily or weekly price action. Overall year-to-date equity performance remains superb and broad-based. As of market close on May 17, the S&P 500 is up 14.1 percent for the year. All 11 S&P 500 sectors are in positive territory and nine are up 10 percent or greater. The Healthcare sector is up a modest 2.1 percent, negatively impacted by “Medicare for All” discussions in Washington. Materials is up 8 percent, which is favorable yet below that of most other sectors due to slow global growth trends and tariff concerns.
- While volatility has been on the rise in recent days, performance remains remarkably strong. Friday’s S&P 500 close of 2,859 is only 3 percent below the all-time closing high of 2,945 reached on May 3.
Another round of economic releases and second quarter results are among upcoming fundamental catalysts likely to impact equity prices. Uncertainties surrounding United States/China trade appear likely to continue for the foreseeable future. The G20 summits scheduled for June 28-29 in Osaka and November 30-December 1 in Buenos Aires are among high profile venues where ongoing trade discussions could take place.
Fixed income markets
While headlines regarding United States/China trade prompted volatility in risk assets, falling inflation expectations and increased investor confidence in upcoming rate cuts by the Fed pressured Treasury yields lower. There is a clear dichotomy between investor expectations versus the Fed’s communication around the future path of policy rates. Multiple Fed officials made comments last week expressing skepticism of cutting rates to spur inflation. Unless data deteriorates materially, we believe it’s unlikely the Fed will cut rates this year given the persistent strength in the labor market and the Fed’s willingness to accept temporary below-target inflation. Minutes from the last Fed meeting will be released this week, shedding further light on the potential path forward. The recent decline in Treasury yields has also lowered the incremental compensation investors receive from extending to longer maturities. Given this limited yield pick-up by extending duration and our belief that risks in Treasury yields are biased higher, we recommend investors favor holding bond portfolios with shorter-than-benchmark maturities.
U.S. corporate, emerging market and levered loan spreads all stabilized last week following a broad selloff the week prior. These spreads all remain slightly below long-term median levels. Valuations appear fair given companies’ strong margins and debt service capacity. However, we are somewhat cautious of riskier high yield debt due to high leverage in the space and the category’s sensitivity to fluctuations in the business cycle. We recommend investors maintain portfolios comprised of primarily high-quality debt to provide adequate diversification against equity and equity-like risk.
Crude oil prices were up last week, with West Texas Intermediate (WTI) climbing 1.78 percent. For the year, WTI is up almost 40 percent. Prices rose even though domestic inventories of crude witnessed an unexpected increase. Oil prices have been on a seesaw recently, caught between the escalating United States/China trade war and geopolitical issues concerning Iran. Going forward, we believe there is more room for prices to trade higher, because it seems more likely the trade war will be de-escalated than it is the Iranian situation will be resolved.
The Alerian MLP Index rose 0.5 percent last week, still benefitting from the announcement of the Buckeye Partners transaction during a general “risk off” environment in the broader market. The index has now outperformed the S&P 500 by more than 3 percent for the year. We continue to view midstream assets as underpriced, with improving fundamentals, increasing cash flow, better corporate governance and greater capital discipline. Maybe increased mergers and acquisitions activity will become the catalyst to propel shares higher. For now, midstream assets continue to trade at a discount to historical fundamental valuations and a higher than average dividend yield.
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