Current economic events
Week of August 12, 2019
Last week started off with a bang, when the People’s Bank of China (PBOC) set the exchange rate of the yuan below seven per dollar for the first time in more than a decade. The action stoked fears that China may begin to systematically devalue its currency to boost its export sector to offset the impact of U.S. tariffs. Concerns were exacerbated when China announced it would no longer purchase U.S. agricultural products. Soon after that, an Institute of Supply Management (ISM) purchasing manager survey (PMI) showed the service sector at its weakest point since August 2016. The impacts rippled across global markets, causing the S&P 500 Index to have its worst day of 2019 while government bonds rallied worldwide. Though fears eased as the Yuan stabilized during the week, tensions have clearly escalated between the two sides, with President Trump on Friday morning threatening to pull the United States out of an expected September negotiation. We see trade policy as an “edgeless” risk (a risk that could likely move markets, but there is insufficient information for the market to price outcomes ahead of the event).
Global central banks are taking notice that both the global growth outlook and trade relations between the world’s two largest economies have deteriorated. On August 6, three central banks — the Reserve Bank of New Zealand, the Reserve Bank of India and the Bank of Thailand — all cut interest rates by more than the market expected. Expectations of the Federal Reserve (Fed) rate cuts have also shot higher, with markets now pricing in a 100 percent chance of a 0.25 percent interest rate cut in September and a 50/50 chance of a 0.50 percent cut. Estimates of somewhat drastic action later in 2019 have also crept up, with market expectations of three or more 0.25 percent cuts in the next few months rising. These expectations of reductions in global interest rates have led to higher prices in sovereign debt markets, with a quarter — $15 trillion — of all government debt trading at negative yields, meaning investors are paying governments to hold the bonds. While the consensus outlook has deteriorated somewhat, there were also reasons for optimism last week, with the Organization for Economic Cooperation and Development’s (OECD) composite leading indicators showing world growth momentum stable for the first time since July 2018.
It was a light week for data releases in the United States. The OECD’s leading indicators showed continued deterioration of growth prospects. Conversely, a survey from Sentix depicted current conditions improving but expectations worsening in August. The Job Openings and Labor Turnover Survey (JOLTS) from the Bureau of Labor Statistics showed openings declining year-over-year for just the third time during this expansion, indicating the labor market is softening from very strong levels. We see U.S. growth having decelerated well off its cycle peak in mid-2018, with trends continuing to be strongly negative.
Foreign developed data generally disappointed again last week. Among eurozone and Japanese survey data, Markit Service sector PMIs, Sentix current situation and expectations and the OECD’s leading indicators all slowed. Hard data was not much better. German, French and United Kingdom (U.K.) industrial production contracted in July, slowing from last month. U.K. gross domestic product (GDP) growth was also cause for concern, showing a quarterly contraction in the economy for the first time since the fourth quarter of 2012. Japan’s second quarter GDP growth, on the other hand, surprised everyone by increasing year-over-year, clicking up to its best rate in a year. Foreign developed growth has meaningfully slowed, with overall health at its worst since mid-2013. However, the pace of the slowing is moderating, a potential sign that a bottoming may be in the works.
The geopolitical tensions were also on full display in emerging markets last week. In addition to China’s currency devaluation, anti-China protests escalated in Hong Kong, with Chinese state media toughening its rhetoric against the demonstrators. India also revoked the statehood of Jammu and Kashmir, a political hotspot in the dispute between India and Pakistan, deploying tens of thousands of troops to occupy the region. While only the currency devaluation is driving global markets currently, these other issues are worth monitoring as major events in two of the largest emerging markets. Markit services PMIs were, on balance, positive for emerging markets. Readings rose in five out of six countries, with four moving into expansion from contraction. OECD leading indicators were more mixed, with China and Brazil improving but India, Korea and Russia weakening. Sentix surveys were less positive, with the three emerging regions — Asia (excluding Japan), emerging Europe and Latin America — all dropping in the headline reading. Chinese inflation data diverged; producer prices deflated year-over-year for the first time since mid-2016 while consumer inflation was the hottest since February 2018. While data downtrends in emerging markets are perhaps slightly more modest than in the developed world, they have persisted for a long time, such that we now see emerging markets close to their worst health since 2009.
U.S. equities experienced an up and down week of trading. The broad-based indices traded modestly off as trade tensions linger and the second quarter reporting period comes to a close. From current levels, it seems plausible that U.S. equities will trend generally sideways for the next month or so, absent meaningful catalysts, driven more by technical versus fundamental influences.
While the S&P 500 closed last week down 0.5 percent, it is up 16.4 percent for the year, reflecting overall equity performance that remains resilient, broad based and superb. Strong year-to-date performance could imply that the recent market volatility is within the normal ebb and flow of a favorable risk-on environment. Defensive sectors led performance, with Real Estate, Utilities and Healthcare posting gains and Consumer Staples unchanged. Perhaps more telling is that, year-to-date, both growth and defensive sectors continue to post strong results. Nine of the 11 sectors are up 13 percent or greater, led by Information Technology (26.3 percent) and Real Estate (23.8 percent). Energy (2.8 percent) and Healthcare (5.6 percent) continue to lag, although they remain positive.
The second quarter reporting period is effectively over, with 90 percent of S&P 500 companies having released results as of August 9. On balance, companies are modestly exceeding expectations while lowering estimates for third and fourth quarters. The lower earnings reset is among reasons to expect overall performance into year-end to lag what has been experienced year-to-date.
- For companies reporting, sales and earnings are up 3.9 percent and 2.3 percent, respectively. Healthcare and Communication Services companies are leading the advance, both posting year-over-year earnings growth of 10 percent or greater. The Energy, Materials, Consumer Discretionary, Consumer Staples and Information Technology sectors are reporting negative year-over-year earnings gains.
- The lackluster earnings growth of Consumer Discretionary and Information Technology, sectors that comprise roughly one-third of the market value of the S&P 500, are among reasons fueling concern that the overall performance of the index is likely to lag what was experienced in the first half.
- Expectations for earnings growth in the third and fourth quarters continue to inch lower. As of August 12, consensus is for earnings to decline 3.3 percent in the third quarter and gain 3.8 percent in the fourth quarter, according to FactSet Research Systems. It is difficult to envision the broad equity market trending meaningfully higher when the pace of earnings growth is trending lower.
- Broad market valuation remains within a “zone of okay,” elevated but still short of extremes. As of August 12, the consensus earnings for the S&P 500 in 2019 is approximately $165 per share, nearly 5 percent above 2018 levels and 17.5 times 2019 estimates.
Among upcoming catalysts likely to impact equity prices are the Federal Open Market Committee (FOMC) meeting scheduled for September 17 and 18 and third quarter releases slated to begin in mid-October. Trade negotiations between the United States and China remain an unknown, with no indication that either side is willing to concede on structural issues. As such, leading up to the next FOMC meeting and third quarter releases, it is likely that market price trends versus fundamental factors are apt to be a bigger driver of price action.
Fixed income markets
Bond yields took another leg lower last week, driven by heightened trade tensions and associated uncertainty surrounding the global economy, weak economic data and falling policy rate expectations across the globe. Depressed yields have reduced the attractiveness of investing in longer-term bonds. However, our preference for below-benchmark duration is modest, due to the strong trend of lower yields despite the relative fundamental unattractiveness of longer-maturity bonds.
The case for more rate cuts later this year by the Fed strengthened due to escalation in the trade dispute with China and dovish comments by Fed officials. The market is currently pricing in a rate cut next month, with the magnitude a toss-up between 0.25 and 0.50 percent. Markets are pricing in a 0.65 percent reduction in the policy rate this year, and another 0.45 percent reduction next year. We agree with sentiment that further cuts are necessary. However, we believe there is risk the Fed will disappoint relative to the aggressive market expectations, in turn bolstering the case for a slight underweight duration stance.
It was a volatile week in credit markets, but spreads remain slightly below 15-year median levels. Higher-quality investment-grade corporate debt outperformed high yield bonds over the past few weeks as investors fled riskier asset classes. We continue to recommend investors maintain proper exposure to high quality bonds. These bonds provide important ballast to portfolios during times of equity market stress. We also favor exposure to structured credit, albeit contained. Structured credit provides the benefit of compelling yield, exposure to U.S. consumer and residential real estate markets (which we see as stronger than corporate credit fundamentals) and added portfolio diversification.
Defensive sectors outperformed last week as interest rates moved lower during another “risk off” (less aggressive) move. Publicly traded real estate investment trusts (REITs) were the best performers, rising 2 percent and outperforming the broader market by more than 2 percent. Although same store net operating income (NOI) growth for REITs declined from the first quarter to the second, NOI growth remains above the long-term average. Additionally, debt capital is available at low rates and valuation measures are steady. Commercial real estate continues to offer attractive forward returns relative to other asset classes.
Crude oil prices, as represented by West Texas Intermediate (WTI), declined 2 percent last week but is up 20 percent for the year. Domestic fundamentals were mixed, with inventories increasing across the United States but declining at the critical storage hub of Cushing, Oklahoma. Domestic production continues near record levels. Price action earlier in the week prompted Saudi Arabia to threaten further production cuts. Although this action boosted prices, growth concerns driven by heightened trade tensions are winning the day. If demand growth continues to be downgraded, the Saudis will need more cuts to keep supply and demand in balance.
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