Current economic events
At first glance, strong global market performance last week probably made investors scratch their heads. Kicking off the week were May manufacturing purchasing manager’s indexes (PMIs) showing global manufacturing falling into contraction for the first time in more than three years. Nearly every major economy slowed during the month and Japan, the United Kingdom and China all dropped into contraction. Later in the week, composite PMIs were a bit better in the developed world, though data from Markit still showed the United States and China worsening. As trade war tensions continued to mount over the past month, U.S. and German exports both fell into contraction. Then on June 7, May payrolls missed expectations by 100,000 jobs and previous months were revised down by 75,000.
The rationale behind the market’s push higher appears to be changing expectations for global central bank policy. In the United States, Federal Reserve (Fed) officials began signaling a willingness for potential rate cuts this year. Chairman Jerome Powell only hinted at the possibility of cuts while other Fed officials were more overt. However, the market isn’t buying Powell’s nonchalance, with futures suggesting most investors are expecting two or more cuts by September. Moving abroad, the European Central Bank (ECB) during its May meeting implemented a generous refinancing package for lenders, hoping to stimulate credit creation and boost persistently weak inflation. Further reporting noted the growing dovishness in the ECB leadership, who feel that both rate cuts and reinitiating the quantitative easing bond-buying program are on the table. Meanwhile, the Royal Bank of Australia spared investors the uncertainty and became the first major central bank in years to cut interest rates and was quickly joined by the Reserve Bank of India and the Central Bank of Chile. With data deteriorating, it’s clear that markets are expecting central banks to come through in a big way, and it’s this dovish pivot that likely explains the burgeoning June rally.
Tariffs remain a front and center issue. While we saw no progress in the United States/China trade negotiations, a June 7 agreement did avert U.S. tariffs on Mexico. Other U.S. economic data was mixed. The jobs report saw the unemployment rate stay at its multi-decade low while growth in average hourly earnings dropped to its lowest level since September. Growth in factory orders also slowed during the month and remain close to stagnant. We see U.S. economic growth well off late-2018 highs and continuing to slow at one of the fastest rates among major world economies.
While there have been some signs of optimism in other European economies, its usual stalwart — Germany — can’t seem to catch a break. On top of contraction in April exports, its central bank, the Bundesbank, slashed its forecast for 2019 growth by a whole percent to 0.6 percent. In addition, industrial production had its worst month since 2014, with growth continuing to contract year over year. Adding to the ECB’s case for stimulus was inflation data, which showed consumer inflation falling sharply in May. Moving to Japan, conditions have mostly deteriorated since the first quarter. On top of its manufacturing sector contracting, Japan’s leading index dropped to its lowest point since 2012, foreboding weaker growth in the already near-stagnant nation. Foreign developed economies continue to struggle to regain uptrends after early-year weakness, though economic trends in Japan now appear to be heading in the wrong direction.
After sharply lower gross domestic product (GDP) growth results in many emerging nations showed the extent of the slowdown that occurred in the first quarter, May PMI data showed these trends unabated in the current quarter. Composite PMI dropped in all major markets tracked, including China, India, Russia, Brazil and South Africa. The latter two dropped into contraction. This bodes poorly for May Brazilian industrial production, which saw a slightly slower contraction in April. Emerging market stock indexes lagged developed counterparts last week, because they continue to be driven by trade relations and economic data, whereas developed stocks have been trading heavily off monetary policy expectations.
U.S. equities remain remarkably resilient, advancing 4.4 percent last week — the best weekly performance since November 2018. Despite the escalation of tariffs on China, sudden willingness to impose tariffs on Mexico and coordinated anti-trust attacks on U.S. technology companies, the S&P 500 closed June 7 at 2,873. The index is up 14.6 percent for the year and a mere 2.5 percent shy of the all-time high of 2,946 reached on April 30 of this year. Last week’s strength was largely attributed to headlines about trade — namely, that the United States would not raise tariffs on Mexico — and hopes that the Fed will cut interest rates.
Following robust year-to-date returns, the near- and intermediate-term outlooks for U.S. equities appear mixed. The backdrop for U.S. stocks into the second half of 2019 and 2020 is largely favorable. Non-problematic inflation, a generally dovish Fed, ramping expectations of a looming rate cut and moderate earnings growth are supportive of a risk-on bias, bolstered by modest multiple expansion. Near-term, despite last week’s strength on the heels of superb and broad-based year-to-date performance, conditions have changed, presumably implying increased future volatility.
- The willingness to impose tariffs on goods from Mexico (or any other country) not tied to trade injects a new level of uncertainty into the market while making things more random and risky.
- Economic weakness trends, both home and abroad, render back-half 2019 earnings estimates vulnerable.
- President Trump (and Washington in general) appears less business-friendly now that federal investigators are looking to investigate the competitive practices of large technology companies.
- Technical price trendlines are less convincing, requiring time to repair, after having fallen below and then rising above key support levels.
The fundamental backdrop surrounding the trends of sales, margins and earnings remain mostly supportive of a risk-on bias, with overall returns in the second half of 2019 likely to be subdued from what is being experienced in the first half.
- Revenue growth projections are trending flat and are no longer being reset meaningfully lower, a positive for equity prices. S&P 500 revenue is currently projected to advance in the 4 percent to 6 percent range year-over-year for 2019 and 2020.
- Profit margins for the S&P 500 are holding up reasonably well, with limited evidence of widespread margin deterioration. Margins do appear near peak levels in the Technology sector and there appears to be some margin deterioration among companies within the Industrial and Consumer Discretionary sectors.
- Consensus earnings estimates for 2019 remain mostly within the $165 to $170 per share range. However, the visibility of earnings for 2019 is lacking, because it is difficult to measure the implications of a full-on trade war. At a minimum, with estimates being back-half loaded, the bias would seem to be down. This elevates the importance of the second quarter earnings period and company guidance, beginning in mid-July.
Our year-end price target for the S&P 500 is 2,970, based on a multiple of 18 times earnings of $165, 3.3 percent above the June 7 close, and toward the upper end of our low-high range of 2,725 (16.5 times earnings of $165) and 3,050 (18.5 times earnings of $165). Absent ramping inflation or a looming recession, the backdrop appears favorable for modest multiple expansion.
Fixed income markets
Bond yields continued to fall last week when Fed commentary opened the door to lower funds rates, trade uncertainty persisted and a weak job report pressured sentiment. The Fed’s “Beige Book” report summarizing regional economic conditions in the United States confirmed our view that the economy is growing but at a sluggish pace. Rates markets now imply high odds of up to three cuts during the remainder of 2019. While the magnitude appears excessive, we agree some degree of accommodation is likely in coming months. Odds of a cut at next week’s Fed meeting are low, but Chairman Powell is likely to signal openness to rate reductions at coming meetings. Various members of the Fed have made comments in recent days implying lower policy rates are on the table. High-quality bonds have continued to outperform riskier fixed income securities and remain a critical part of diversified portfolios. We continue to favor below-benchmark maturity profiles, given the minimal compensation for extending duration, and reduced utility of longer maturity bonds as diversifiers when rates are as low as they are.
Corporate credit spreads (the incremental yield available beyond that of comparable maturity U.S. Treasuries) are near normal historical levels after widening recently. However, fundamentals have deteriorated somewhat, trends in U.S. economic data remains challenged and rates markets imply monetary policy is restrictive. As such, we continue to recommend normal allocations to investment-grade corporates relative to U.S. Treasuries and remain neutral on high yield corporate bonds despite wider spreads.
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