Weekly market update

Markets and Investing

 

Week of January 14, 2019

Current economic events
Global markets continued to move higher last week on hopes that the Federal Reserve (Fed) will back off its rate hiking path in response to more volatile financial markets and weaker business surveys in the United States. Even as sentiment picked up, global economic data continued to deteriorate in the first full week of 2019.

After a positive jobs report to kick off the year, key U.S. economic data was decidedly negative last week. The most focus was on a services sector purchasing manager index (PMI) from the Institute of Supply Management (ISM), which declined to a five-month low. Additionally, an all-sector survey from Sentix showed business conditions dropping to a two-and-a-half-year low. Inflation data also foreshadowed weaker growth, with headline consumer inflation falling and core inflation unchanged. Finally, data from the National Federation of Independent Business depicted declining optimism among small businesses. The partial government shutdown continues into its fourth week, but economic impacts should be modest. Supplemental Nutrition Assistance Program (SNAP) benefits were extended through February and President Trump may sign a measure guaranteeing back pay to federal workers when the shutdown ends. The U.S. economy appears to be resynchronizing with the rest of the global economy and moving into a phase of slowing growth, though economic fundamentals are still healthy relative to the rest of the world.

Japanese data was relatively mixed last week while most European numbers pointed to an economy trending strongly downwards and overall growth flattening. Surveys from Sentix showed extreme pessimism among eurozone businesses in a rapidly deteriorating situation, though data from the European Commission showed a slowing but healthier picture currently. Germany, France, Italy and Spain (the four largest European economies) all saw industrial production contract year over year in November after three of the four grew in October. Eurozone retail sales growth also slowed in November. Sticking out from the weakness was the eurozone unemployment rate, which hit a cycle low in November, though labor data tends to lag other growth indicators. In Japan, the Leading Economic Index (LEI) continued to contract, but it outperformed very pessimistic consensus expectations. Bank loan growth has continued to increase, showing that the credit cycle hasn’t turned despite softer data. Even as Japan’s economic momentum seems to be stabilizing, the eurozone continues to weaken rapidly and now looks near stagnant or even contracting.

With the upward turn in sentiment has come strength in emerging market asset performance. Emerging market indices were showing strength even before the holidays, with MSCI Emerging Markets providing modest gains through last week while foreign developed stocks (MSCI EAFE) and U.S. stocks fell over the last three months of 2018. In a possible boon for sentiment, the United States and China held mid-level trade talks that resulted in some positive takeaways, including a commitment from China to buy more U.S. goods and services. However, a report that the Chinese government plans to cut its 2019 gross domestic product (GDP) growth target and reiterate its inflation target showed that the extent to which the government is willing to stimulate the economy is somewhat limited. This comes as China’s headline consumer and producer inflation hit six-month and two-year lows, respectively, in December and China trade numbers were disappointing. In India, industrial production growth slowed to its weakest rate in 18 months while Brazilian and Mexican production moved into contraction. The emerging market economic environment, in aggregate, looks quite weak, with a majority of data points below historical averages and in a downtrend.

Equity markets
U.S. equities are on a roller coaster ride, with the year-to-date direction up following the 2018 price decline. On balance, the outlook remains mixed. The fundamental backdrop of moderating earnings growth, non-problematic inflation and relatively low interest rates appears generally positive for stocks while sentiment and technical indicators suggest caution. We expect volatility to remain elevated into the fourth quarter earnings reporting period, with overall equity performance in 2019 being positive, yet subdued from historical levels.

The fundamental backdrop provides valuation support while serving as the basis for a risk-on bias. Consensus earnings estimates for the S&P 500 for 2019 and 2020 are roughly $170 and $190, respectively. The fourth quarter earnings season unofficially begins this week, with approximately 7 percent of S&P 500 companies slated to release results during the week, led by many money center banks. With consensus estimates beginning to trend lower, fourth quarter releases will shed light on the magnitude of earnings revisions, the pace of global growth and the degree to which lingering trade tensions are impacting company results.

Sentiment remains mixed, with near-term performance improving while valuations are compressing.

  • Following lackluster performance in 2018 when the popular broad-based indices all retreated and six of 11 S&P 500 sectors declined 10 percent or more, performance in January has been superb. As of January 11, the same broad-based indices are up between 2.9 and 7.3 percent and the small cap-oriented Russell 2000 is up 7.3 percent, nearly double the 3.6 percent gain of the S&P 500. Additionally, all 11 S&P 500 sectors are posting gains so far in 2019, led by the 8.1 percent gain of the Energy sector and 6 percent gains of the Communication Services and Consumer Discretionary sectors.
  • Valuations appear compelling. The S&P 500 trades at roughly 17 times trailing 12-month estimates, below the 25-year year average of 19.3 times. Similarly, on forward estimates, the S&P 500 trades at roughly 14.5 times 2019 estimates, below the 25-year average of 17.3 times. The valuation argument is compelling only if earnings hold, and earnings estimates are trending lower as the benefits from tax changes wane and in response to global economic slowing.

     

Technical price trends remain under repair, with time needed before technical support can be provided. The S&P 500 ended 2018 in violation of key support and moving average levels. What once were key levels of support have become key levels of resistance. Price trends in early 2019 have improved. The S&P 500 closed January 11 at 2,596, fractionally below technical resistance at the 2,600-2,650 range.

On balance, many of the items that impacted equity prices in 2018 – lingering trade tensions, Fed action and commentary, falling oil prices, moderating pace of global growth, Washington-related uncertainty and associated political wrangling – are among items expected to impact prices in 2019. This presumably implies continued volatility. Our year-end 2019 price target for the S&P 500 is 2,800, based on a multiple of 17 times consensus earnings of $165, roughly 8 percent above current levels. We continue to favor growth-oriented sectors and companies that are outgrowing their peers and the overall economy, absent ramping inflation and a looming recession.

Fixed income markets
Rates rose while stocks and risky bond prices continued to rebound last week. Over the weekend, however, weak trade data in China prompted caution among investors. A slew of U.S. data is on tap this week, though some releases may be delayed due to the government shutdown. Fears of a Fed policy error have eased slightly. Minutes from the Fed’s December meeting were released, indicating a more cautious and data-dependent tone than was evident from December statements. Muted inflation and slowing global growth gives the Fed room to pause the rate hike cycle in coming months. However, economic data would likely need to deteriorate meaningfully to justify the current market pricing of zero rate hikes this year and an 80 percent chance of a rate cut in 2020. We continue to recommend that the primary component of bond allocations in diversified portfolios remain high quality investment-grade bonds, with slightly lower than normal maturity profiles.

We continue to recommend a balanced exposure to investment-grade credit relative to Treasuries and remain neutral, with a negative bias, on high yield credit. Credit spreads (yield over Treasuries with similar maturities) tightened last week, supported by the Fed’s dovish tone, and are near historical medians. High yield credit fundamental levels are weak, based on interest coverage, leverage and liquidity metrics, while credit trends are mixed. Investment-grade credit fundamentals are mixed, with slightly positive trends. Sentiment in credit markets has shifted positive, reversing the extreme negative sentiment that gripped markets in December. The primary risk in the near term remains shifting investor sentiment rather than an increase in defaults.

Real assets
Publicly traded real estate investment trusts (REITs) gained 4.5 percent last week, outperforming the S&P 500 by almost 2 percent. For the year, REITs have outperformed the broader market by 0.7 percent. The decline in interest rates has given the real estate market a little breathing room by increasing the spread between commercial mortgage rates and property earnings yields. However, that gap is still small by historical standards, which caps upside price potential for properties. Going forward, performance in property markets will ultimately be driven by growth in free cash flow. To that end, we have witnessed a slowing in cash flow growth. As of now, we believe growth will be sufficient to keep property prices from collapsing, and investors should be able to earn the dividend yield of property investments and a small amount of capital appreciation for a total return in the mid-single digits.

Oil market performance so far in 2019 has been spectacular after a terrible 2018. West Texas Intermediate crude increased 7.5 percent last week and is up more than 13.5 percent for the year. Domestic producers continue to pump record amounts of oil and domestic supplies have declined from recent highs. Additionally, domestic inventories are significantly below the supply overhang that existed in 2016 and 2017. OPEC production cuts went into effect on January 1. If OPEC can maintain its discipline, it should be able to trim the mini supply glut and stabilize prices.

Price recovery in oil markets has caused a massive rally in midstream energy infrastructure this year. While past performance is not a guarantee of future returns, the Salient midstream fund was up 4 percent last week and is up over 11 percent for the year, outperforming the S&P 500 by 8 percent. Fundamentals in the industry are improving. Free cash flow is growing and corporate governance is improved. We believe total returns in the space will be low- to mid-teens annualized over a seven-year holding period.