25 Feb 2019
Be Careful What You Wish for in the U.S. Market
Equity investors have been cheering the sharp rebound seen since the end of last year, with the S&P 500 up more than 16% since the Christmas Eve low. We don’t want to be buzzkills and we enjoy rallies as much as anybody; but equity gains that come rapidly after sharp corrections can have consequences as well. It didn’t take long for sentiment to move from overly pessimistic to overly optimistic according to the Ned Davis Research (NDR) Crowd Sentiment Poll; somewhat concerning given the contrarian nature of investor sentiment, especially at extremes. We believed that U.S. stocks had gotten to oversold levels and were likely pricing in too great a risk of a near-term recession—so a rebound was to be expected. But some of the declines seen toward the end of last year were justified in our minds as economic growth has been slowing, trade uncertainties remain, government dysfunction persists, and corporate sentiment is deteriorating. In short, we don’t believe we’ll revisit the lows seen late last year if a recession remains a 2020 story, but a retrenchment of some of the recent gains seems likely. If a recession looks to be developing this year—and if there is no trade deal and additional tariffs kick in—those market lows could be retested (and beyond).
Economic growth slowing, while an earnings recession becomes more likely
U.S. economic growth, while remaining in positive territory, has definitely slowed courtesy of tighter financial conditions last year, weak global growth, the trade-related denting of “animal spirits,” and the effects of the government shutdown. Also of note has been the upside breakout in initial unemployment claims; as well as the decline in banks’ willingness to make loans, showing more caution among financial firms and providing reduced capital to business.
The Institute for Supply Management (ISM) Non-Manufacturing Index fell in its latest reading, moving to 56.7 from 58.0, while the forward-looking new order component fell more sharply to 57.7 from 62.7—both still above the 50 mark which denotes expansion versus contraction, but not moving in the right direction.
This slowdown is clearly impacting the earnings story as well. Expectations were relatively subdued coming into the fourth quarter 2018 reporting season, which may have helped companies hurdle the bar. At the same time, companies reporting stronger earnings have been rewarded with higher stock prices—in contrast to the general trends of last year. But stocks tend to focus on the windshield, not the rear-view mirror, and the deterioration in earnings expectations for this year are notable. According to Refinitiv (formerly Thomson Reuters) first quarter estimates are now in slight negative territory, with the subsequent two quarters both in low single-digit territory—making the valuation case less attractive.
More dovish Fed…but why…and for how long?
Some of the U.S. stock market rally since year-end 2018 can be attributed to a more dovish Federal Reserve. At the January Federal Open Market Committee (FOMC) press conference by Chairman Powell, he appeared to go out of his way to emphasize that the FOMC is now “patient” and no longer in the “gradual hike” camp. A more friendly Fed is welcomed, but why the change? Is it because they believe the fed funds rate is near the “neutral rate,” or are they becoming more concerned about both U.S. and global economic growth? Additionally, while fed fund futures are pricing in roughly zero chance of rate hike this year, we can’t ignore the tightness of the labor market and upward pressure on wages. If wages continue to rise, filtering through to the broader economy, the Fed could be forced to step back in—not to move to neutral, but rather to tighten in order to battle a perceived inflation threat. This is a risk likely underappreciated by investors, which could contribute to greater volatility as we move through the year.
The U.S.-China trade dispute deadline of March 1 may have gotten a reprieve, with President Trump open to letting the 90-day “trade truce” be extended; meaning an extension to the increase in tariffs from 10% to 25% on many imported Chinese goods. Since early 2018, when the United States announced the first set of tariffs, the trade balance between the United States and China has widened, with U.S. exports to China slowing.
Yet, indications from the Trump administration and Chinese officials suggest an extension of the “trade truce” may be the outcome on March 2. With this extension, we anticipate no increase in tariffs—but no removal of existing tariffs either. The easing of trade tensions seemed to help fuel the January rally in stocks, with an 11% gain in the MSCI China index and an 8% in the S&P 500 index of U.S. companies. But the optimism may have run its course, as the focus of trade disputes may see Europe and Japan trading places with China.
Stock market investors remain concerned about barriers to trade, especially as global growth slows. With another 90-day trade window beginning to tick down to a tariff deadline, investors may have fresh concerns that could weigh on stocks. Investors might also downgrade their expectations of a U.S.-China trade deal as they see the Trump administration renew tough talks on trade.
Markets got a healthy reprieve from last year’s fourth quarter carnage as a few headwinds became tailwinds; including a more dovish Fed, some hopes on trade, strong fourth quarter earnings growth, and an end to the government shutdown. But there are lurking risks, including equities having become technically overbought, and investor sentiment having moved back into the high optimism zone. We continue to recommend investors remain near their long-term equity allocation, using rebalancing during bouts of volatility and keeping portfolios diversified across asset classes.
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 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.
Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.
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 MSCI China Index captures large and mid-cap representation across China H shares, B shares, Red chips and P chips. With 153 constituents, the index covers about 85% of this China equity universe.
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 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