Week of September 16, 2019

Current economic events

A sea change was underway last week, despite the steadily rising S&P 500 flirting with all-time highs. Bond yields reversed sharply higher (prices fell) after months of dropping while equity-style factors, like value, momentum and high volatility, had daily divergences not seen since the depths of the financial crisis. From a policy standpoint, it was hard to discern notable changes. The European Central Bank (ECB) met expectations with its stimulus package of a 0.1 percent cut in interest rates — a tepid restart to its quantitative easing (QE) bond-buying program — and a tiering of interest rates to help banks that are suffering from inverted yield curves across Europe. Trade news was perhaps a bit brighter, with President Trump leaving the possibility open for an interim deal with China while China made concessions on some agricultural products. However, we continue to remain skeptical of the potential of a deal in the near term, given the large gaps between the two parties on core issues, such as intellectual property theft and the United States’ trade deficit.

U.S. economic data was relatively mixed last week, though consumer data continues to impress. Headline retail sales growth was the fastest since October while control group sales (excludes food services, car dealers, building-materials stores and gasoline stations), which is strongly related to gross domestic product (GDP), was the best since May 2018. Core consumer, as well as headline and core producer inflation, picked up. Core consumer inflation hit an 11-year high, which should give the more hawkish members of the Federal Reserve (Fed) further reason to hold off on rate cuts. However, core inflation typically lags the economic cycle, and headline consumer inflation fell. Sentiment data was also mixed. University of Michigan consumer sentiment rose slightly while National Federation of Independent Business optimism index ticked lower, though it remains at historically high levels. Labor data was less positive, with the Job Openings and Labor Turnover Survey (JOLTS) showing job openings contracting at the fastest rate in two years. Labor data, such as job openings, lags the business cycle and will likely continue to deteriorate in the near term. We continue to see the United States economy trending strongly downward, though August and September data has come off July lows.

Foreign developed data was also mixed last week. Sentix’s surveys were consistent across the regions, with expectations rising but current situations falling. The eurozone’s industrial production growth rose slightly in July but remains in contraction as weakness in Germany continues to drag down the area. Data in the United Kingdom was generally stronger, with growth in construction output, industrial production and manufacturing production rising while unemployment fell. Japan’s industrial sector, on the other hand, looked weaker, with growth in core machinery orders dropping sharply into contraction and growth in machine tool orders contracting near its fastest rate of the cycle. Foreign developed economies continue to trend downward, though currently at a slower rate than a few months ago.

Emerging markets appear weak, with data showing Chinese stimulus is not reaching the same heights as it did during the 2015-2016 slowdown. Although growth in Chinese total social financing has risen, credit and money supply growth are near lows; officials continue to signal that China is unlikely to reopen the floodgates. Due to the more tepid easing measures, inflation is not showing up for industrial businesses, with producer deflation increasing in August. Exports also fell back into contraction, though downtrends in trade appear to be easing. Consumer inflation in Mexico continued to dive, dropping to its lowest rate since October 2016. South Korea was a bright spot, with its unemployment rate realizing its largest one-month drop since 1999, the aftermath of the Asian financial crisis. Brazilian retail sales growth also picked up to an eight-month high. Emerging markets continue to look weak, though a burgeoning uptrend in China’s OECD (Organization for Economic Cooperation and Development) leading indicator bodes well for these economies.

Equity markets

The Goldilocks-like “not too hot, not too cold” economic backdrop remains supportive of a risk-on (more aggressive) bias, with U.S. equities, on balance, appearing priced to perfection with a narrow margin of error. While corporate fundamentals remain in an information quiet period following second quarter results and in anticipation of third quarter results beginning in mid-October, inflation, interest rates and pace of earnings growth are all at levels that are supportive of equities. Sentiment is mostly positive, bolstered by fair valuations and superb, broad-based performance. Also, technical trends reflect strong momentum, with the S&P 500 beginning the week of September 16 trading above 50-, 100- and 200-day moving averages. The drone strikes and crippling of the Saudi oil production over the weekend is undoubtedly going to weigh on sentiment in the near term.

• The fundamental backdrop for a risk-on bias remains intact, bolstered by non-problematic inflation, low interest rates, moderate earnings growth and uninspiring alternatives. In recent days, improving United States/China trade headlines, improving U.S. economic data, dampened geopolitical tensions and expectations for more Fed support have all helped propel equity prices higher.
• The tame inflation and low interest rate environments have helped pushed U.S. equity price-earnings multiples and prices higher. Looking toward year-end and 2020, it seems plausible that equity prices will continue to have an upward bias as long as the Fed remains on a path toward lower rates. To that end, this week’s Federal Open Market Committee rate decision will presumably impact equity prices this week and in the days to follow.
• The pace of earnings growth remains an overhang. Expectations are for earnings to decline 3.9 percent in the third quarter over year-ago levels. While expectations are for the pace of earnings growth in the fourth quarter of this year and first quarter of 2020 to be reset lower, the year-over-year comparisons begin to ease after the third quarter, thus elevating the importance of third quarter results and forward guidance.
• The decline in interest rates also continue to fuel the appetite for income alternatives, such as dividend-paying equities. At present, roughly 60 percent of S&P 500 companies offer dividends yielding above that of the S&P 500, affording investors both income and appreciation potential.

Sentiment is being bolstered by fair valuations and broad-based performance. The path forward is likely to reflect more volatility, with overall returns more subdued, particularly if escalation follows the attack on Saudi Arabia’s oil supply.

• The S&P 500 trended higher last week, marking the third consecutive week of gains. For the year, the index is up 20 percent, with all 11 sectors in positive territory and nine up 15 percent or greater. By many metrics, the risk/reward seems balanced, making it hard to envision meaningful upside into year-end from current levels.
• Small-capitalization companies and emerging markets are outperforming recently. Last week, the small cap-oriented Russell 2000 and MSCI Emerging Markets indices outpaced the S&P 500 by nearly a two-to-one margin, which typically is indicative of economic stability.
• U.S. equities have become a buy high, sell higher market, with the S&P 500 ending last week a mere 0.5 percent shy of all-time highs of 3,025 reached on July 26. In this sense, U.S. equities appear modestly overbought, supportive of the notion that stocks are priced-to-perfection with a narrow margin of error.

Fixed income markets

Long-term Treasury yields surged higher last week on improving investor sentiment around United States/China trade relations, supportive inflation data, overbought technical conditions and strong investment-grade corporate issuance pulling money from the Treasury market. Sovereign yields outside the United States also rose following improving investor sentiment. Yields then pulled back slightly over the weekend, after attacks on Saudi oilfields sent stocks lower and oil prices higher. The ECB implemented a package of accommodative measures, including a lower policy rate and ongoing asset purchases. The Fed is expected to follow in the ECB’s footsteps this week by cutting the funds rate by 0.25 percent for the second time this year. Investors will be focused on the Fed’s guidance for the future path of rates, considering the rate cut is fully priced in by markets. Market participants dialed back expectations for future rate cuts last week but are still pricing in four more rate cuts by the end of 2020, including this week. It may be difficult for the Fed to satisfy investors looking for a stronger commitment to ongoing rate cuts, and uncertain monetary policy may continue driving elevated yield volatility.

High-quality bonds remain a critical component of well-diversified investment portfolios. The recent surge higher in yields provides an attractive opportunity for investors who have been investing in bonds with very short maturity profiles to extend into maturities closer to their benchmark.

U.S. corporate and emerging market credit spreads tightened last week. U.S. investment-grade and high yield credit spreads are now well-below their 15-year trailing medians, indicating investors are receiving less compensation than normal for taking on their credit risk. U.S. investment-grade corporations have been taking advantage of lower borrowing costs to refinance, issue new debt and extend debt maturities. Corporate bond issuance has been significant in recent days, although investor demand remains strong and spreads have consequently held relatively steady.

Real assets

Crude oil prices, as represented by West Texas Intermediate (WTI), declined 3 percent last week but are still up 21 percent for the year. Domestic fundamentals remain supportive, with another large decline in domestic crude inventories and inventory declines across all refined products. However, the news the market is currently following is the terrorist attack on a large Saudi production facility over the weekend. Houthi rebels from Yemen have claimed responsibility, but U.S. Secretary of State Mike Pompeo has blamed Iran. As of Monday, both WTI crude and Brent crude were already up more than 10 percent. The damage to the facility is expected to take more than 50 percent of Saudi production offline, which amounts to 5 percent of daily crude production. Prices could rise higher if the shutdown lasts longer than expected. At a minimum, prices should continue to be supported; it appears the crude market was trading with too small of a risk premium. Global oil infrastructure is spread across thousands of remote miles and is susceptible to attack. It is nearly impossible to secure all assets. Given this fact, it is hard to be short energy assets.

Energy assets had another good week and have had a very strong September. Since August 27, exploration and production companies are up more than 22 percent and midstream infrastructure is up 8 percent. We believed these sectors were cheap, but lacking a catalyst for a sustained rally. The past two weeks have seen a large rotation out of momentum stocks into value, where these sectors now reside, leading to massive outperformance. Since valuations of these assets are cheap, there is significantly more room to rise. One could make the argument that the midstream space should really be considered a defensive sector. Midstream companies have much more stable cash flows than energy exploration and production companies — and the typical value stock, for that matter. Distributable cash flows are growing significantly, and dividend coverage ratios have been increasing. Additionally, the latest capital expenditure cycle is winding down, which could increase distributable cash flows even further in 2020. The midstream sector could be a much less volatile way to get exposure to the energy complex at this turbulent juncture.

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