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10.29.18
Further signs of a strong U.S. economy fail to derail a slump in global equities
The last week’s market highlights:
Quote of the week:
"The airplane stays up because it doesn’t have the time to fall.” – Orville Wright
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Q4 Outlook:
- U.S. economy: Still running ahead of its peers.
- Global economy: Trade a bigger concern outside the U.S.
- Policy watch: Trade risks haven’t bitten the U.S. yet, but that may change.
- Fixed income: Continue to position for rising rates.
- Equities: The price is right outside the U.S.
- Asset allocation: Finding pockets of opportunity.
Equities: Investors continue to sing “Bad Moon Risin’”
It’s perfectly natural—healthy, even—for stocks to take a breather after a period in which returns outpaced earnings considerably, as they did from late 2014 through the first few weeks of 2018. Certainly, shares now valued around 15x forward earnings have thicker cushions to absorb disappointing future earnings results than they did back in January, when they were valued at about 18x. But that still doesn’t explain why the S&P 500 Index has dropped about 9% in October so far. Amid the plethora of negative headlines accompanying this selloff, there were positive developments last week, even if they were seemingly buried in the small print.
For starters, the U.S. kicked off the fourth quarter in fine form. Markit’s “flash” (preliminary) Composite Purchasing Managers’ Index (PMI), which tracks the manufacturing and service sectors, hit a three-month peak of 54.8 in October, well above the 50 mark separating expansion from contraction. Gains in new orders supported higher levels of business activity, with improving domestic economic conditions driving client demand. Encouragingly, despite the possibility that the U.S. will follow through on its threatened 25% tariff on $267 billion of Chinese imports, the outlook for business activity brightened, especially among manufacturers. At the same time, however, the effects of tariffs seem to be taking a toll. Export growth slowed, while cost pressures heated up.
Providing additional succor for equity bulls—rare as they might be these days—was the staying power of U.S. companies, which continue to pump out solid quarterly results. Through October 26, nearly half of S&P 500 Index companies have reported third-quarter earnings. Among the highlights:
- Year-over-year earnings and sales jumped a robust 23% and 9%, respectively, just below the 25% and 9.5% recorded last period.
- 82% of companies have registered earnings surprises, topping the second quarter’s 80% total.
- Earnings and sales have beaten forecasts by about 6% and 1%, respectively, in line with last quarter’s tallies.
So why have equity markets been in such a foul mood—not just last week but for the month of October? Investors have been grappling with a host of issues, including fears that U.S. corporate profits growth might have peaked, Italy’s budget situation could herald a new eurozone crisis, and the global economy may be slowing, fueled by the U.S.-China trade dispute. To illustrate:
- Although industrial bellwether Caterpillar beat third-quarter earnings and revenue estimates, its shares tumbled after management revealed that tariffs had raised the cost of materials by $40 million in the third quarter. Similarly, 3M was hurt amid forecasts of higher costs this year ($20 million) and next ($100 million).
- The eurozone economy suffered its worst month in more than two years, with Markit’s Composite PMI for October dropping to 52.7. The pace of manufacturing activity in the region plunged to a near four-year low, damaged by a tariff-driven decline in exports. Service-sector activity also weakened substantially. Not surprisingly, business optimism hit its lowest level since November 2014.
- Italy remains a sore spot. On October 23, the European Commission rejected the budget proposed by the country’s populist government. Tensions over Rome’s plans to run a deficit of 2.4% of GDP in 2019—a significant increase over previously agreed targets—have led to higher interest rates in Italy, the eurozone’s third-largest economy. The yield on 10-year Italian government bonds has jumped almost 30 basis points (0.30%) this month.
Policy watch: Mario puts his foot down
Despite disappointing eurozone growth and angst over Italy, on October 25 the European Central Bank (ECB) confirmed plans to halt its quantitative easing (QE) program by the end of the year. Repeating prior guidance, the ECB also said it expects to keep interest rates at their present record-low levels “at least through the summer of 2019, and in any case for as long as necessary.”
Italian legislators have called for the ECB to extend its QE asset purchases, which would help restrain Italy’s borrowing costs. ECB President Mario Draghi hit back by asserting that the central bank’s mandate is “a mandate towards price stability, not towards financing governments’ deficits.”
Meanwhile, President Trump stepped up his criticism of the Federal Reserve’s interest-rate increases. Although Fed Chair Jerome Powell, Draghi’s U.S. counterpart, did not respond, his second-in-command, Fed Vice Chairman Richard Clarida, indicated in an October 25 speech that more rate hikes are in store if the U.S. economy stays on track, as the Fed anticipates.
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