17 June 2019
Potential Opportunity may Emerge Amid Bouts of Weakness in the U.S. Market
May saw the U.S. equities pull back between 7-10% as trade tensions and growth concerns ratcheted up. After a solid rally since the early-June lows, the question now is: Is there more weakness to come?
We never try to time every near-term peak or trough in the U.S. stocks; but we are concerned some of the issues which have rattled the U.S. market could get worse. First, the trade dispute with China could escalate even further as the United States is looking at imposing tariffs on the remaining ~$325 billion in Chinese goods that U.S. companies import. Additionally, trade talks with Europe have deteriorated recently and the threat of U.S. tariffs on all Mexican imports were dual escalations in the global trade battle. Due to tariffs’ growing impact, as well as weak global growth, S&P 500 earnings estimates for the second quarter have been in retreat—Refinitiv now shows a negative year-over-year earnings expectation. In addition, a historically fairly reliable predictor of recessions has flashed yet another warning; with the yield curve inverting again.
Although the story is relatively grim, we never suggest investors should head for the exits. May’s selling pressure helped relieve overly optimistic investor sentiment conditions that had accompanied the late-April market highs, helping set up the opportunity for the bounce since early June. There may be further chipping away at optimism to set up for a more sustainable move upward; especially if the latest rally leads investors to do a sentiment about face. What else could be catalysts for a durable rebound? We’ve already seen instances of perceptions about trade turning on the proverbial dime (or tweet); and we could certainly see that again. An upside surprise on trade could make for a more sustainable rebound. In addition, it’s important to remember that the stock market is a forward-looking mechanism, so much of this quarter’s earnings and economic weakness in the U.S. may already be reflected in prices. We continue to think that risks are roughly balanced at the current time and that investors should continue to stay near their long-term equity allocations, using strength to pare back holdings if necessary. Within U.S. equities, we continue to favor large cap stocks at the expense of small cap stocks due to the latter’s weaker earnings outlook and significantly higher debt levels.
State of the economy
As noted, a weaker second quarter appears to be reflected in the U.S. stocks, but what does the U.S. economic data tell us about the potential for future quarters? On the surface the 3.1% growth rate for the U.S. real gross domestic product (GDP) in the first quarter looked healthy, but it was biased up by inventories and net trade, both of which appear to be reversing in the second quarter. Absent a significant cooling of trade tensions, economic risk now seems tilted to the downside. Manufacturing surveys have suffered, as a much weaker Markit PMI reading was followed by a softer Institute of Supply Management (ISM) Manufacturing Index. To some degree, it has filtered through to the service side as well, with weakness seen in Markit’s services index (although the ISM non-manufacturing reading did move slightly higher, bucking the trend). For now, all of the above remain in territory depicting continuing economic expansion, but the general deterioration bears close watching.
Consumer confidence in the U.S. surprisingly rebounded in May reading (although it may not reflect the latest escalation in the trade war and attendant stock market pullback), and initial jobless claims remain historically low after a brief period of a rising trend.
Fed remains on hold
The mixed economic picture has kept the Federal Reserve in a holding pattern since January; although Fed Chair Jerome Powell sounded a dovish tone in a recent speech, noting that the Fed is monitoring the escalation in trade tensions and will act “as appropriate” to sustain the economic expansion. The U.S. market is now pricing in close to a 90% chance of two rate cuts by the end of the year, the Fed has not corroborated the U.S. market’s extremely dovish view in its recent commentary. At some point the U.S. market or the Fed will be forced to adjust their respective views; with the process of convergence possibly adding to volatility in the stock market.
Peaks in consumer confidence occurred in the United States and Europe in 1989-90, 1999-00, and 2007, just ahead of prior global recessions. The most recent slump in Europe could reverse, with another surge in confidence to an even higher peak than the current cycle peak of 2018; but, it is a worrisome sign for the global economy that the peak was near or above the levels where prior cycle peaks occurred.
We won’t speculate about the final outcome of ongoing trade tensions, but we are growing more concerned that the hit to business confidence will increasingly filter through to consumer confidence and hard economic data. A more positive outcome could elongate the runway between now and the next recession. In the meantime, we continue to recommend that investors maintain a relatively neutral stance consistent with long-term asset allocations, using inevitable gyrations to rebalance as needed.
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.
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 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 Institute for Supply Management (ISM) Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms by the Institute of Supply Management. The ISM Non-manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.
Markit Manufacturing Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index includes the major indicators of: new orders, inventory levels, production, supplier deliveries and the employment environment.
Markit Services Purchasing Managers Index (PMI) released by Markit Economics captures business conditions in the services sector.
The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
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