Week of January 20, 2020
Current economic events
U.S. markets continued to march higher last week. Optimism around last Wednesday’s signing of the “phase one” trade deal between the United States and China and the ongoing recovery in global economic sentiment were foremost in investors’ minds. The initial trade deal has the U.S. halving tariffs on $120 billion in Chinese goods in exchange for China’s promise to buy an additional $200 billion of American goods over the next two years. While the reduction in tensions has soothed markets, much of the economic impact remains; the average duty on Chinese goods is up to 19 percent from 3 percent before the trade war began. Progress on structural issues, such as forced technology transfer, was largely pushed out to a potential “phase two” deal, meaning tensions — and tariffs — are likely to persist for the foreseeable future. Meanwhile, much of the evidence of a global economic recovery came from abroad. However, continued strong housing and retail sales in the United States boosted the narrative that last year’s interest rate cuts provided the support to kick the housing sector into high gear and keep U.S. consumers strong. Amid the recovery in business sentiment and construction, our proprietary U.S. economic Health Check, a statistical measure of the average health of current economic data, improved to a nine-month high. Downtrends in place since late-2018 have eased, perhaps indicating a recovery in economic growth this year.
Foreign developed markets have participated in the global recovery rally, though to a lesser extent than the U.S. stock market. In many areas, data has hardly stabilized, much less accelerated. Despite some encouraging signs that eurozone and Japanese industrial production may have bottomed, hard manufacturing, construction and inflation data from the United Kingdom continued to drag on our foreign developed economic Health Check. The measure registered a new low in January, posting its lowest reading since August 2013 and showing few signs of regaining an uptrend. Also depressing sentiment is the potential for escalation of U.S./European Union (E.U.) trade tensions. Issues relating to airplane subsidies, digital taxes and the World Trade Organization have sprung up over the past year and may rise in importance in coming months if President Trump shifts his focus to U.S.’s sizable trade deficit with the E.U.
A weak U.S. dollar and rising commodity prices have helped emerging market stocks keep pace with the S&P 500 in recent weeks and have helped jumpstart global trade. (When the dollar weakens, it boosts the performance of international assets that are in currencies the dollar is weakening against.) The bulk of the ongoing positive swing in global sentiment has come from China, where a stabilization — and maybe reacceleration — appears to be underway. Investors are highly focused on credit and liquidity information; December data showed that China’s monetary stimulus is reaching the real economy, though credit creation remains notably weak. This fed into a stabilization of December retail sales and fourth quarter gross domestic product (GDP), while industrial output growth rose to multi-month highs. Chinese trade data was also helped by the waiving of some U.S. tariffs in December, with growth of both imports and exports surging. The jump in trade has also been beneficial to trading partners like South Korea, which has also regained an uptrend in our emerging markets economic Health Check.
U.S. equities are in the early days of the fourth quarter reporting season with the S&P 500 at all-time highs, closing Friday at 3,329. Accommodating central banks at home and abroad, restrained inflation, relatively unattractive alternatives and optimism for year-over-year earnings growth in 2020 are among items helping to propel equity prices to record highs.
The S&P 500 continues to exhibit superb and broad-based performance in 2020, similar to what was experienced in 2019. Nine of 11 S&P 500 sectors are in positive territory in January, led by Information Technology (5.9 percent) and Communication Services (5.2 percent). Energy and Materials are the two sectors that are trending in negative territory so far.
The fourth quarter reporting season ramps this week, with the bulk of S&P 500 companies reporting by the end of February. With 9 percent of S&P 500 companies reporting information so far, results are mixed. As of Friday’s close, sales are up 1.7 percent, modestly below expectations for a 2.3 percent year-over-year increase, according to FactSet Research Systems. Earnings, conversely, are trending fractionally higher, up 0.9 percent, beating expectations of -1.7 percent over year-ago levels.
Financials (20 percent of companies), Consumer Staples (15 percent) and Consumer Discretionary (10 percent) are the three sectors with the greatest percentage of companies within each sector having released results. On balance, banks are reporting modest loan growth, slightly higher expenses, challenging net interest margins and improved capital markets activity. Weighing on many bank share prices are valuations, with many banks trading between double and 2.5 times tangible book values, levels that are near historic highs. For select consumer companies that have reported and missed expectations, a common theme is that the shortfall is attributed to the shortened holiday sales period this year between Thanksgiving and Christmas and relatively low inventory levels that resulted in product outages and unmet consumer demand.
We continue to believe that earnings growth, and not multiple expansion (increases in price-earnings ratios), will be the primary driver of equity prices in 2020. Consensus expectations are for earnings in 2020 and 2021 of roughly $175 and $195 per share, respectively, approximately 10 percent over prior-year levels, according to Bloomberg, FactSet Research System and S&P Global. The S&P 500 ended Friday trading at roughly 19 times forward 12-month earnings estimates — above the 30-year average of 17.1 times — a level widely considered elevated, yet short of extremes.
Technical price-trend indicators reflect strong momentum, with the S&P at all-time highs, thus encountering no upside resistance. Conversely, the popular index is arguably overbought, with Friday’s close being above respective 50-, 100- and 200-day moving average levels.
Our published single-point year-end 2020 price target for the S&P 500 is 3,400, based on 20 times earnings of $170 per share. The upper-bound of our price target range of 3,570 is based on a multiple of 21 times earnings of $170. We intend to review our assumptions and price targets after first quarter releases begin in mid-April.
Fixed income markets
Treasury yields were relatively unchanged last week, since economic data released did little to adjust market expectations for growth and inflation. Recent comments from Fed officials have confirmed that support for maintaining the current policy rate is broad-based. Short-term rates will likely be relatively stable in the near-term should the Fed follow through with this plan. We expect longer-term Treasury yields to be rangebound, with an upside bias, due to our expectation for modest growth and inflation this year.
The rally in risk assets this year has extended to nearly all corners of the corporate bond market. Last week, corporate credit spreads (corporate bond yields compared to Treasuries) held steady near multi-year lows across most sectors and rating buckets. Even the lowest-quality bonds, CCC-rated securities that were shunned in 2019, have participated in the recent rally. We expect strong demand for corporate bonds to continue as fourth quarter earnings reports confirm leverage is high across the market, but debt remains serviceable. Investment-grade and high yield corporate bond returns are likely to be limited this year, because these tight spreads give investors little compensation for taking on credit risk. However, it is paramount that investors maintain appropriate high-quality credit exposure to provide proper diversification from riskier holdings.
Defensive sectors of the market (Real Estate, Infrastructure and Utilities) traded higher last week, and all outperformed the broader market. Utilities were best among the three, beating the S&P 500 by 1.7 percent. Real Estate was worst, but still outperformed the S&P 500 by 0.5 percent. For the year, Real Estate and Infrastructure are trailing the S&P, while Utilities are outperforming. All the annual gains for the defensive sectors occurred last week. However, we see these sectors as fully valued and with decelerating income growth. It will be hard for these sectors to outperform in 2020 unless global economic growth disappoints and interest rates move to lower levels.
Crude oil prices, as represented by West Texas Intermediate, declined 0.8 percent last week and is down 4 percent for the year. The primary catalyst for the move lower has been the de-escalation of U.S./Iranian tensions. However, in the past week domestic fundamentals were also negative for prices. We saw a small decline in inventory and large increases in inventories of refined products, such as distillates and motor vehicle gasoline. Furthermore, domestic production increased to a new all-time high and rig counts had an unexpected rise. The crude oil market has experienced price spikes in response to increased tensions in the Middle East, but the increases have been subdued. Additionally, the market has retreated from those higher prices quickly. This tells us the market is not currently worried about a lack of supply.
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