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Are U.S. Market Risks Bubbling Below the Surface?

We never want to put too much into a few days of trading, up or down, but we also don’t want investors to get lulled into a false sense of security. There are some developments bubbling a bit below the surface which have raised our concern about risks to the U.S. stock market. The stock market is a forward-looking indicator. As we often say, when it comes to connecting the dots between the economic/earnings fundamentals and the stock market, “better or worse tends to matter more than good or bad.” We’re concerned that some economic indicators are showing signals of “second derivative” (rate of change) inflection points; even if many of them remain healthy in terms of their levels. In terms of the stock market, over the past three months, the defensive sectors of health care, utilities, telecom and consumer staples have outperformed according to the S&P 500 sector breakdown, indicating some growing caution among investors. We believe it’s prudent for investors to review the risk profile of their portfolios and make sure they’re not above the comfort zone. In fact, for the more tactical investors among you, we have reduced the risk profile of our sector recommendations by downgrading our view of the technology and financial sectors to neutral, while upgrading our recommendation to the utilities and real estate sector, also to neutral.

Additionally, we’ve seen the U.S. Citi Economic Surprise Index move into negative territory. This doesn’t mean that the economy is contracting, just that economic data is increasingly missing elevated expectations.

“Don’t fight the Fed” still relevant?

Few investors would argue against the notion that the massive quantitative easing (QE) coming out of the financial crisis helped to fuel stock gains. We are now in an era of quantitative tightening (QT)—through both balance sheet reduction, but also interest rate increases—and it’s naïve to assume the move toward monetary policy normalization won’t bring some significant jolts to market performance.

For now, we are coming off what was a very strong earnings season, with a beat rate of 79% on earnings and 72% on revenues according to Thomson Reuters, well above the historical average beat rates of 64% and 60%, respectively. Additionally, analyst estimates for the coming quarters are ramping up. We have some concern that companies’ ability to best these elevated expectations may be diminished; and while earnings will likely continue to be good, they may be a little “less good.”

The bear is likely to stay in hibernation…for now

Risks are growing, but we don’t believe a bear market is around the corner. Barring a black swan-type shock, we believe the next bear market will come when it begins sniffing out the next recession, which we don’t see in the near-term. Economic growth remains healthy, although possibly at or near its peak in growth rate terms; while inflation has been accelerating. Tax cuts are still having a positive impact on consumers and businesses; and the Treasury just issued final guidelines on repatriation, so we should start to see even more corporate money coming back to the United States from overseas. Both should help the U.S. economy weather the ongoing trade uncertainty as well as tighter monetary policy, but higher inflation is taking a bite out of nominal data, like wage growth (“real” wage growth has dipped into negative territory).. So far, the impact has been minimal on the employment data, with the leading indicator of jobless claims remaining at multi-decade lows.

The tight labor market has aided the increase in most inflation indexes; possibly pushing the Fed to be more aggressive in their rate hiking campaign. All three closely-watched “core” inflation indexes—Consumer Price Index (CPI), Personal Consumption Expenditures (PCE) and Underlying Inflation Gauge (UIG)—are near or above the Fed’s 2% target. In addition, notice how the UIG has tended to lead the other two measures, which suggests upward pressure on inflation will persist. Although the stock market has priced in two more rate hikes this year, a faster-than-expected pace in 2019 could lead to elevated volatility, especially if we enter a phase of weakening economic growth and accelerating inflation. Investors may not be prepared for higher inflation, which would could put further downward pressure on real economic and wage growth. For now, we think the secular bull market remains intact, but are reinforcing that investors should tactically keep equity allocations no higher than neutral relative to long-term strategic allocations.

So what?

The recent pickup in market volatility, some choppy action by U.S. stocks, and notable weakness in emerging market stocks have reinforced our belief that we may be at or near an inflection point in economic fundamentals and/or market character. We never suggest trying to time the market in the short-term, but do believe discipline around strategies like rebalancing and diversification is essential at this stage in the cycle. Risks are rising.

 

Important Disclosure

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

The Citi Economic Surprise Indices measure data surprises relative to market expectations. A positive reading means that the data releases have been stronger than expected and a negative reading means that the data releases have been worse than expected.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The Consumer Price Index (CPI) is an index that measures the weighted average of prices of a basket of consumer goods and services, weighted according to their importance.

The core PCE Price Index is personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

Content provided by Charles Schwab, Hong Kong
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