8 Oct 2019
U.S. Stocks Have Been Relatively Stable in the Absence of Trade Escalation
While U.S. stocks emerged out of their tight range a couple weeks ago, they have yet to surpass their July highs—as trade uncertainties remain, economic data continues to be mixed, and cloudy monetary policy and political outlooks persist. U.S. equities’ breakout to the upside was accelerated by a rapid factor reversal that favored small-cap and value stocks—strategies that have not worked for investors in the current bull market. Yet, this turned out to be a very short-lived phenomenon and we are back in an environment that tends to favor large-cap, low volatility and momentum stocks. Larger cap companies have lower debt levels than their smaller cap brethren; are more nimble with regards to trade; and have a global presence, making it possible for them to borrow at negative rates. These fundamentals, along with the fact that a record percentage of smaller companies have soaring debt levels (as measured by the S&P 600’s debt-equity ratio of 124%), continue to support our large cap bias.
A divided economy
Economic data has been mixed of late, keeping firm the line that separates services/consumer strength from manufacturing’s weakness. The U.S. Census Bureau reported that retail sales rose 0.4% m/m in August, along with an increase in personal consumption of 4.6% in the second quarter (as per the Bureau of Economic Analysis). In addition to still-low jobless claims and a tight labor market, the overall picture for the consumer remains fairly bright. Yet, strength may start to wane if trade uncertainty continues to weigh on sentiment and/or the remaining tariffs kick in later this year. This may be starting to show up in consumer confidence which—as measured by The Conference Board—fell sharply in September to 125.1 from 134.2 in August. The decline came along with a drop in the difference between the Consumer Expectations Index and the Present Situation Index—which is still firmly negative. It is important to keep in mind that this index tends to trough (shortly) in advance of recessions, while consumer confidence tends to peak at the same time.
Conflicting data within manufacturing and services
An erosion in consumer data—which could be precipitated by the threatened October 15 and December 15 tariffs that hit consumer goods—may accompany weakness that has started to appear in the services sector. The recent Markit “flash” Purchasing Managers’ Indexes (PMIs) for September revealed a bit of an uptick in the headline numbers—with manufacturing rising to 51 and services to 50.9 (both above 50, which separates expansion from contraction). Notwithstanding manufacturing’s modest rebound, the underlying data was a bit worrisome for services this time around. Subdued demand resulted in the first employment reduction on the services side of the economy in just under 10 years. This supports our view that if the malaise in manufacturing were to bleed into services, it would most likely show up first in the employment channels.
The path for interest rates is not set in stone
As expected, the Federal Open Market Committee (FOMC) cut interest rates by 25bps at its September meeting. There were three dissents—the first time since 2016—with Kansas City Fed President Esther George and Boston Fed President Eric Rosengren suggesting no cut at all, and St. Louis Fed President James Bullard in favor of a 50bps cut. Separately, the median of the FOMC’s “dots plot” signaled no change in rates for the rest of the year—which half of the members agree will be the case moving forward.
The FOMC also decided to cut interest on excess reserves (IOER) by 30bps, which exacerbated some unease amidst the New York Fed’s recent interventions in the repo market. While this has spawned chatter of quantitative easing (QE), these liquidity injections represent technical fixes at this point. Because the funding market has tightened, making bond purchases difficult to finance, the Fed has engaged in repurchase agreements (“repos”) to bring the effective federal funds rate (EFFR) back into the Fed’s target band. The market gets worried when there is a shortage of liquidity, mostly because the most leveraged players can get squeezed (causing adverse reactions), but the repos do not signal that a major financial institution is in imminent trouble.
The lack of trade news has kept volatility subdued lately, but stocks have still made limited headway over the past 20 months. Considering the potential for political headlines to change and trade tensions to escalate at any moment, we continue to believe that trading around short-term news is a treacherous exercise. As such, our recommendation continues to be that investors stay near their long-term asset allocation but use volatility to rebalance back to strategic allocations; while we continue to favor large caps relative to small caps within U.S. equities. With much uncertainty remaining with regards to trade, monetary policy, politics, and the economy, the path ahead for stocks appears no less choppy than it has been in prior months.
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.
Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
The Consumer Expectations Index is a component of the Consumer Confidence Index® (CCI), which is published each month by the Conference Board. The Expectations Index is made up of the average of the CCI components that deal with six-month outlooks for business, employment, and income.
The Present Situation Index is a sub-index that measures overall consumer sentiment regarding the present economic situation. This index is determined via survey conducted by The Conference Board, and is used to derive the Consumer Confidence Index. This is also sometimes known as the Current Situation Index.
The Markit ‘Flash’ PMI is an estimate of the Purchasing Managers' Index (PMI) for a country, based on about 85% of total PMI survey responses each month. It is intended to provide an accurate advance indication of the final PMI data.
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, and the source of comments provided here.
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