A Brief Update on the Markets

“From the Desk of Michael Sheldon, CIO”

Earnings season is moving into high gear with about 40% of companies in the S & P 500 reporting their results this week.  So far about 78% of companies are beating estimates (which have already been lowered in many cases) which is in line with the 5-year average.  The latest estimate for year over year EPS growth for the S & P 500 this quarter is currently minus 3.9%.  For next quarter, estimates are currently for year over year EPS growth of -0.5%, before profit growth turns positive again and rises over the remaining two quarters of 2019.  For 2020, the current estimate is for a return to double-digit year over year EPS growth of 11.5% with all 11 sectors forecast to generate positive year over year EPS growth (note: 7 out of 11 S & P 500 sectors are currently forecast to generate double digit growth).  The outlook for corporate profits is certainly not encouraging to start this year, but importantly, the forecast starts to improve after a weak start to the year.

When driving, it’s always best to look forward rather than backward in the rearview mirror.  The same rule of thumb applies to investing.  The U.S. economy hit a rough patch in late 2018 and early 2019 as investors increasingly priced in the likelihood of recession.  However, the economy now appears to be on somewhat better footing during the second quarter of the year.  For reference, employment, retail sales, housing and other economic data that all missed forecasts at some point over the past several months now appear to be back on track.

In terms of monetary policy, in late 2018 the Federal Reserve Bank previously indicated that additional rate hikes were likely to take place throughout this year.  However, after reviewing several different economic statistics, monitoring the behavior of financial markets, and evaluating economic trends overseas, the central bank changed course earlier this year.  Instead of additional rate hikes this year, the central bank has now signaled that more rate hikes are unlikely for the rest of 2019.  While the market is currently betting that the next change in rates by the central bank will be a cut, we believe that the next change in rates is just as likely to be a rate cut as a rate hike  (when that occurs somewhere down the road likely in 2020).  Importantly for the markets, the change in Fed policy has helped reduce the level of risk in financial markets and has lowered the chance of a recession over the next few quarters.

Earlier this year some economists and investors were concerned that GDP growth in the first quarter would be close to 0%.  The Atlanta Federal Reserve Bank (which tracks quarterly GDP) actually forecast that first quarter GDP would register just 0.3% in early January.  However, as of April 19 (their latest update), the Atlanta Federal Reserve bank has now raised their estimate of first quarter GDP up to a level of 2.8% (note: the actual number will be released this Friday). The economy grew at a rate of 2.2% in the fourth quarter of 2018, 3.4% in the third quarter and 4.2% in the second quarter of 2018 (readers can probably see a trend in these numbers).  If first quarter 2019 GDP comes in around current estimates, that would importantly break the recent trend of weaker growth that we have seen over the past several quarters.

With employment continuing to grow, consumer confidence at healthy levels and wages on the rise, the U.S. consumer (which represents about two thirds of the U.S. economy) currently appears to be on pretty solid footing.  Data on industrial production and factory usage suggest that industry trends have slowed somewhat in early 2019 compared with previous years.  Recent surveys of corporate CEO’s have weakened somewhat (likely due to concerns about trade and overseas economic growth) and this is a trend to monitor.  Worth noting, the ISM Manufacturing Index remains above 50 (55.3 as of the latest reading) indicating the manufacturing side of the economy continues to grow at a moderate rate.

Overall, we don’t see the economy or corporate profits rising at the same pace as in 2018, but we still believe the economy appears likely to generate moderate growth in 2019.  A technical recession (marked by two consecutive quarters of negative GDP) just does not appear likely at this time.  With the S & P 500 currently trading at 16.8x estimated next 12-month earnings, valuation levels are no longer cheap (as they were at the start of 2019).  However, inflation and interest rates remain subdued.  In addition, a majority of leading indicators such as weekly jobless claims, credit spreads and the monthly leading economic index remain positive.  There are some areas of concern on our radar.  For example, the Federal Reserve Bank’s Senior lending survey tightened somewhat last quarter (note: this has historically led to slower growth 2-3 quarters down the road) and the yield curve (the spread between 3 month and 10 year yields) briefly inverted last quarter (note: this has historically forecast a recession with a fairly long lead time) before turning positive again.

Overseas, headwinds continue to blow especially in Germany (as well as other parts of Europe) and Japan, for example. Exports and manufacturing activity in Germany and Japan have been quite weak in recent quarters.   In Italy (the third largest country in Europe), GDP has been negative for two consecutive quarters.  On a more positive note, we have started to see some signs of improvement in China.  It’s hard to believe all of the statistics coming out of China.  However, recent data shows that industrial output, fixed investment, retail sales, exports and the money supply have all started to improve in recent weeks.  It’s too soon to sound the all clear but at least data from China (the second largest economy in the world) now appears to be moving in the right direction again.

Then, there is trade. After the U.S. threatened to raise tariffs up to 25% on Chinese imports last year, the two sides started to make progress on a possible trade deal.  Negotiations with China are ongoing and there is no guarantee that a comprehensive long-term deal will be achieved.  However, recent news reports have been somewhat encouraging and more talks are scheduled over the next several weeks.  Our expectations remain that trade issues will likely start to resolve themselves in the months ahead. If trade talks ultimately produce a lasting agreement between the two sides, that should help reduce economic uncertainty and could provide a much-needed lift for global growth.  If that does not occur, there could very well be some fallout (at least over the short term) in global markets.

So far in early 2019, the bulls hold the upper hand (after taking a drubbing in late 2018).  Looking at various parts of the market (i.e. the performance of semiconductor and transportation stocks, consumer discretionary versus consumer staple companies along with the performance of copper prices and credit spreads) we believe that there are some reasons to be positive.  We have also made it through the government shutdown and the Mueller report (for the most part).  However, we acknowledge that there are certainly risks facing the market including negative earnings to start the year, the potential for a breakdown in trade negotiations between the U.S. and China, weak economic growth in Europe and other parts of the world along with rising debt levels in many countries. Looking long-term, we are concerned that when the next recession comes, the world’s central banks will largely be out of ammunition to help boost economic growth.

Equity markets have come pretty far over a relatively short period of time this year.  As a result, we would not be surprised if there was a pause or brief pullback as investors digest recent market gains. At least for now, we continue to believe that a U.S. recession seems like a low probability event over the next few quarters.  Looking ahead, the Federal Reserve Bank is patiently watching things unfold, the U.S. consumer appears pretty healthy, interest rates and inflation appear unlikely to rise very much from current levels and a trade deal with China should help remove uncertainty that has held back economic growth around the world.  At current market valuation levels, it will take a continued rebound in economic growth and corporate earnings to help generate additional market gains.  We remain moderately positive in our outlook for 2019 but acknowledge that economic and market risks remain.

As always, we welcome any comments you may have.


Michael Sheldon


Sources:  Factset


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