18 Nov 2019
U.S. Stocks Have Surged on Hopes of a Near-Term “Phase One” Trade Deal Yet Major Issues Remain Unresolved
Take it to the limit
U.S. stocks have broken out to the upside and surpassed their all-time highs. Recent gains have come on the heels of increased hopes of a signed “phase one” deal by year-end; the Fed’s accommodative rate cut in October; and better-than-expected results from October’s payroll data. Yet, though the past month’s rally has been confirmed by cyclical leadership and relative strength within small-cap and value stocks, caution is warranted; as earnings growth in the third quarter is still expected to be negative year-over-year according to Refinitiv data, investor sentiment is approaching excessively optimistic levels, and a “skinny” U.S.-China trade deal is unlikely to lift corporate animal spirits. More broadly, U.S. real gross domestic product (GDP) growth estimates for the fourth quarter—as measured by the Atlanta Fed’s GDPNow forecast—have edged down to 1% as of November 5, 2019.
Slow versus steady
The initial release of third quarter U.S. GDP was 1.9%, which beat the consensus expectation of 1.6%, but was down from 2% in the second quarter. While the headline number reflects moderate growth at best, economic activity has decisively weakened since the beginning of the year. Most of the weakness has been concentrated in the business sector while consumer spending has held up fairly well.
Many pundits have opined that the strength of the consumer has been and will be enough to hold up the U.S. economy, despite myriad uncertainties and an ailing business community. Yet, the reality is that business investment’s ultimate impact carries a lot more heft than its 14.3% weight (measured by the Bureau of Economic Analysis) in overall GDP. In fact, in nearly half of the 41 negative quarters of GDP since World War II, business investment turned negative while personal consumption stayed positive. Thus, even if the consumer remains solid in the near future, it doesn’t necessarily portend a meaningful rebound in growth if business investment continues to wane. There are high correlations among business confidence, corporate profits, capital spending and ultimately job growth. Those are the transmission mechanisms on which to keep a close eye. For now though, the dividing line between business and consumer confidence remains firm; as does that between manufacturing and services.
One hopeful sign for the U.S. economy would be continued stabilization in global manufacturing. Unlike in past cycles, since the U.S.-China trade war began, global manufacturing trends have been leading those in the United States; with optimism building around the benefits of global fiscal stimulus.
October’s payrolls report from the Bureau of Labor Statistics (BLS) was quite favorable, considering the lowered expectations due to the now-concluded General Motors (GM) strike. Notwithstanding the rather muted increase in average hourly earnings, which kept the year-over-year gain at a steady 3%, job creation was strong. The economy added 128k nonfarm payrolls with net upward revisions totaling 95k for the prior two months; and though the unemployment rate ticked up to 3.6% from 3.5%, it rose for the “right reason” in that the labor force participation rate rose. Our view has been that should the malaise in business/manufacturing start to morph into the consumer/services sides of the economy, the weakness will likely show up first in the employment channels. Based on still-low unemployment claims and healthy hiring data, we can say for now that the employment backdrop stands firm; although job openings have rolled over and bear watching.
Pause for effect
As expected, the Federal Open Market Committee (FOMC) cut rates by 25bps at the October meeting and lowered the interest rate on excess reserves (IOER) by 25bps. Most notable was the committee’s hint at shifting into pause mode for the foreseeable future, as Federal Reserve (Fed) Chair Jerome Powell dropped the pledge to “act as appropriate to sustain the expansion” from his press conference statement. Powell signaled that, going forward, the FOMC will monitor incoming data to assess whether further cuts are needed; as a strong labor market, solid job gains, and firm consumer spending have propped up the expansion.
While volatility has remained subdued and U.S. stocks are at all-time highs, a near-term concern is that investor sentiment may be getting a bit too frothy. The potential signing of a “phase one” U.S.-China trade deal and rollback of some tariffs has contributed substantially to the rally; yet the proposals made have yet to be corroborated by anything in writing. Further, absent a trade deal that covers the major structural issues surrounding intellectual property (IP) theft, technology transfers, and supply chains, we find it difficult to envision a resurgence in corporate animal spirits and business investment—stabilization is more likely. Conversely, a positive shift in global growth may be in its infancy stages, as a more widespread adoption of fiscal stimulus may bode well for economies that have leaned too much on easier monetary policy. With many developments still at stake, we maintain our neutral stance on U.S. equities and both developed and emerging market equities; and encourage investors to use volatility to rebalance and stay near their strategic asset allocations.
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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
Kevin Gordon, Senior Specialist