Week of July 8, 2019
Current economic events
U.S. stocks had a festive Independence Day week, leading most global markets and continuing to perform well after their best June in 30 years. Aiding the rally was incrementally positive United States/China trade news out of the G20 summit, where President Trump and China President Xi Jinping agreed to an expected trade truce and to restart trade talks, though the latter has yet to occur. Also contributing were further indications from the Federal Reserve (Fed) that it has lost its “patience” and may cut interest rates as soon as the end of this month. A strong jobs report on July 5 did little to dampen the stock market’s solid performance last week. However, the report did help encourage the futures market to cut chances of a 0.5 percent interest rate cut in July to nearly zero. The jobs report showed the U.S. adding 224,000 jobs, although the unemployment rate ticked up due to a growth in job seekers. Labor market indicators and still-solid consumer confidence remain key supports to the U.S. economy. Other sectors of global data have been less robust, including the JP Morgan global purchasing manager index (PMI), which showed global manufacturing activity remaining in contraction. Composite business activity is trending down in every major economy, though most remain in expansionary territory rather than in contraction.
Outside of the strong jobs report, U.S. data was negatively biased last week. Growth in factory orders fell to a nearly three-year low and manufacturing activity also continued to look weak in PMI surveys. Construction spending contracted at its fastest rate since June 2011. The trade deficit also widened in May, with imports outpacing exports, which may cause a drag on second quarter gross domestic product (GDP) growth prospects. Overall, we see U.S. economic data trending downward and expect the pace of expansion will return to near its longer-term trend in the coming quarters.
Last week ensured there will be some level of continuity, if not necessarily stability, in the European financial system going forward. International Monetary Fund (IMF) President Christine Lagarde was nominated as the incoming head of the European Central Bank (ECB) to replace Mario Draghi, while German center-right European Popular Party leader Ursula von der Leyen was nominated to lead the European Commission. Lagarde, in particular, is seen as a firmly “establishment” figure and will likely follow similar policies as the notably dovish Draghi. With respect to hard data, eurozone purchasing surveys were stronger in June; French data has shown notable strength of late. United Kingdom numbers were less positive, with the composite survey falling into contraction for the first time in more than three years and the construction sector slowing sharply. Eurozone producer inflation continued to slow during the month, and inflation generally has been trending lower since October. Purchasing manager surveys were more mixed in Japan, with manufacturing contracting at a faster pace and the service sector expanding at a faster pace. Overall, developed country data generally weakened in June as softness in Japan, the United Kingdom and Germany outweighed strength in France.
June purchasing manager data mostly eased in emerging markets. Composite readings fell in China, India and Russia, but improved in Brazil. Developing markets have struggled relative to the United States, because slower growth and trade have disproportionately impacted the less established economies. Emerging market investors would likely cheer a removal of trade tensions between the United States and China, though we believe the G20 accord still does not remove the main overhang of fundamental differences between the United States and China. Data in nearly every major market has softened, and we currently see emerging markets, in aggregate, at their weakest economic health since late-2015.
U.S. equities trended modestly higher last week in a shortened week of trading. The S&P 500 advanced 1.7 percent and closed July 5 at 2,990, after posting an all-time high of 2,995 on July 3. Favorable fundamental, sentiment and technical trends are propelling equities to record levels. Data from the next four weeks is likely to set the tone for equity performance into year-end. This includes second quarter earnings releases and forward guidance beginning in mid-July, the Fed’s rate decision on July 31 and the July employment report. Our published year-end S&P 500 price target of 2,970, which is toward the upper end of our target range, is under review with upside bias. We intend to revisit our assumptions and price target in early-August, after reviewing the bulk of company releases and forward guidance.
Restrained inflation, relatively low interest rates and moderate earnings growth are among fundamental factors supportive of a risk-on bias, albeit with equity performance in the second half likely to be more subdued from what was experienced in the first half.
- Sales growth estimates remain generally stable, projected to trend up in 2019 in the 4 percent to 5 percent range year over year, according to FactSet.
- While margins are near peak levels, margin deterioration does not appear to be widespread.
- Earnings growth is a concern, with estimates for 2019 and 2020 trending down. The second quarter reporting period ramps next week, when several money center banks report. Much focus will be on forward guidance and the overall pace of global growth. Expectations for second quarter earnings growth are low, projected to decline 2.7 percent over year-ago levels. June’s stronger-than-expected employment report is one indicator suggesting that earnings could surprise to the upside.
- Inflation, yield curve, credit spreads, manufacturing, employment and housing trends are soft, yet not at levels that would warrant a risk-off bias.
Sentiment remains strong, evidenced by favorable broad-based performance and valuations that are still short of extremes.
- Performance is broad-based and superb, with few or no indications of ramping inflation or a looming recession. The S&P 500 ended last week with all 11 S&P 500 sectors in positive territory for the year; 10 are up 10 percent or greater and five have advanced more than 20 percent.
- Valuations remain near historical levels, neither at high nor low extremes, a positive position. The S&P 500 trades at roughly 19.5 times trailing 12-month earnings estimates — modestly above the 40-year historical average of 17.5 times — and nearly 18 times forward 12-month estimates, which is slightly above the 17.1 historical average. On balance, valuations remain within a “zone of okay,” elevated but short of extremes.
- Lingering trade tensions, rising geopolitical risks and an estimated slowing in the pace of earnings growth are among items suggesting that equities are priced to perfection with a narrow margin of error, all supportive of a balanced outlook for second-half equity performance. While sentiment in the near term has improved following G20 Summit discussions between Presidents Trump and Xi, the timing and magnitude of any looming new trade agreement remain an unknown. With no indication that either side is willing to concede on structural issues, this seemingly implies increased future volatility.
Technical trends reflect strong momentum, with the S&P 500 trending at or near all-time highs. As such, U.S. equities have become a buy high, sell higher market.
- The S&P 500 closed at all-time highs of 2.995 on July 3 and closed July 5 above 50-, 100- and 200 daily moving averages. Clearly, momentum has returned.
- With earnings estimates for the next four quarters trending lower and lingering uncertainties surrounding second quarter results and forward guidance, it seems plausible that U.S. equities are short-term overbought, perhaps subject to a pullback. At a minimum, they can be characterized as priced to perfection.
Fixed income markets
Bond yields increased on July 5 after a strong payroll report. A 0.25 percent cut from the Federal Reserve (Fed) is fully priced in by the markets for the end of July, although odds of a more aggressive 0.50 percent cut fell to near-zero. Expectations are also high for further stimulus from the European Central Bank (ECB) in coming months by way of lower policy rates and additional bond purchase announcements. All eyes will be on Fed Chairman Jerome Powell’s testimony before Congressional panels this week to glean insight into his current thinking around the likely trajectory of policy rates. Minutes from the last Fed meeting will be released Wednesday and inflation data Thursday will offer additional information. The current flatness of the yield curve limits the reward for extending into longer-term maturity bonds, while risks in yield movement remain two-sided. We continue to recommend the primary component of bond portfolios remain high-quality securities with strong diversification characteristics versus stocks and other riskier portfolio allocations.
Expectations of easier monetary policy, combined with reasonably good domestic economic data (albeit trending lower), has continued to drive credit spreads lower. U.S. and emerging market credit spreads have been wider 70 percent to 75 percent of the time over the past 15 years, indicating lower investor compensation for incurring risk. Riskier high yield and emerging market investments are more expensive than higher-quality U.S. investment-grade debt based on current credit spreads relative to history. We advise exposures to high yield debt remain contained due to valuations, elevated leverage and modestly deteriorating credit fundamentals. However, it is investor sentiment around trade and monetary policy that is likely to continue steering the direction of risk assets in the near term.
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