August 13, 2019

“If I ain’t already fallin’ I guess it could be said I’m walkin’ mighty close to the edge” 



Given the myriad of market-moving macro headlines in the past month, it was easy to forget that earnings season was also in high gear. Just over 70% of companies had reported as of July 31, and results have generally been better than expected. Even so, companies have become more vocal around risks presented by the unresolved tariff dispute with China, and some industries in particular (mostly automotive-related) have been struggling with weaker overseas markets in China and Europe.  The percent of S&P 500 companies lowering guidance prior to earnings season was also higher than normal, which helped manage down expectations. Against that backdrop, a larger-than-average 74% of companies have exceeded consensus earnings estimates (i.e. better than the average Wall Street analyst forecast). The magnitude of the average beat was also higher than typical at 6.1%.  This positive trend relative to expectations contrasts with the S&P 500’s modest 2.5% year-over-year earnings growth rate, which is well below that seen in recent periods (see Figure 1).

On a sector basis, information technology (IT) has been the standout, with earnings beating estimates by an average of 8.4%, and 71.9% of companies reporting above-consensus results. Texas Instruments, Intel and Micron, among others had strong results, as customers increased orders to avoid supply chain issues or buy goods ahead of potential tariffs.


Concerns about an earnings recession, typically defined as two or more consecutive quarters of year-over-year earnings declines, have been lurking in the background this year as investors search for signs of a slowing economy or market peak. While slower growth is indeed a reality in 2019, current estimates suggest an earnings recession will be avoided, or short-lived if one does take place.  This is good news for the equity market, as earnings declines lasting only a few quarters have historically not portended lasting stock market drops. 


Trade war escalation pressures growth 

Of course earnings season has played second fiddle to the U.S.-China trade conflict, with tensions again rising sharply. Whatever goodwill was achieved by President Trump and President Xi meeting face to face in late June – after which President Trump declared, “We’re right back on track” – has quickly evaporated. We predicted things were likely to get worse before getting better, and that view drove our equity risk reduction recommendation earlier this summer. While we think a worst case scenario of rapidly escalating tit-for-tat measures will be avoided, the status quo of heightened tension is likely to remain with us for the foreseeable future. This could mean additional U.S. tariffs in the coming weeks, as well as increased Chinese pressure on U.S. firms operating in the region. For more details on the trade war, see our August 6 current market news piece: Currency Shots Fired: U.S.–China trade war rages on.


Heightened trade tensions come at a delicate time for the global economy. Expectations for global growth had been rebounding from the low levels of late 2018, as evidenced by the performance of S&P 500 companies with a high relative percentage of foreign sales (see Figure 2), but that has reversed course more recently. The J.P. Morgan Global Composite Output Index did post a mild uptick to 51.7 in July, yet still hovers precariously close to the demarcation line (50) between expansion and contraction. Manufacturers continue to struggle, as that component of the global index remains in contraction territory for the third straight month, and reached the lowest level since 2012 in July. No doubt the fall in international trade is weighing on manufacturers around the world.

Turning to the U.S., the most recent data from the Institute for Supply Management (ISM) also shows deterioration in the manufacturing backdrop (see Figure 3); though in this case it still registers in expansion territory. Non-manufacturing businesses are demonstrating stronger growth, though at a slower rate than that seen in previous months (see Figure 3). Similar to comments on many quarterly earnings calls, ISM respondents cited ongoing concerns related to tariffs, while describing overall business conditions as “mixed.” Another area referenced in the ISM report was the tight labor market, which helps explain why consumer confidence is near a ten-year high (see Figure 4). The recent decline in interest rates should also benefit the consumer in the form of lower debt service payments and housing market support. All told, our slow and steady growth thesis remains intact. While the U.S. economy has indeed lost some steam in 2019, it is poised to continue in expansion territory. 


Fed watch intensifies

Increased policy uncertainty, slower global demand and low inflation drove the Federal Open Market Committee (Fed) to cut rates in July for the first time since the financial crisis. While future reductions were not guaranteed, the Fed said it “will act as appropriate to sustain the expansion”, which suggests additional rate cuts may be on the way, given the trade war escalation and potential economic fallout. Target rate probabilities now suggest about a 50% chance of up to four interest rate cuts by the end of April 2020! While this may prove to be an overshoot, it is likely that the Fed will act again in 2019 (and perhaps more than once). Of course the Fed is not alone in their work, as central banks around the world have shifted into easing mode in an effort to increase inflation expectations and improve economic output. While our contention remains that interest rate levels and access to capital are not the primary driver of slower growth at this stage (policy uncertainty is), unified central bank action certainly doesn’t hurt.

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