Hot fun in the summertime for U.S. stocks—will corporate earnings keep it going

Brian Nick

The last week’s market highlights:

Quote of the week:

“But here I am in July, and why am I thinking about Christmas pudding? Probably because we always pine for what we do not have. The winter seems cozy and romantic in the hell of summer, but hot beaches and sunlight are what we yearn for all winter.” – Joanna Franklin Bell, Take a Load Off, Mona Jamborski  
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s Midyear Outlook :
  • U.S. economy: Late cycle but no recession
  • Global economy: Still looking for a bottom    
  • Policy watch: Easy monetary policy to offset restrictive trade policy  
  • Fixed income: Volatile interest rates but no breakout in either direction 
  • Equities: Get defensive, stay invested 
  • Asset allocation: No longer “risk on,” but still prefer emerging-market bonds  

Equities: Curb your enthusiasm    

The aphorism “80% of success is showing up” seems a particularly apt description of how equity investors must have felt as the first half of the year concluded. Simply staying in the market paid handsome dividends. Despite a series of headwinds, including U.S. recession fears, trade tensions and weak data releases from China and Europe, equities generated stellar six-month returns.   
Among equity market categories, U.S. large caps (+18.8%) and mid caps (+21.4%) topped small caps (+17%). Growth stocks (+21.4%) continued to dominate value shares (+16.1%). Outside the U.S., developed-market equities (+14% in U.S. dollar terms) outperformed their emerging-market counterparts (+10.6%).
So what’s in store for stocks in the second half of the year?
Tougher sledding, in all likelihood. The global growth landscape remains uneven. Moreover, investors have already priced in lower interest rates, meaning a near-term rate cut (or two) by the Federal Reserve would do little to boost stocks. And of course, there’s the U.S./China trade standoff. As we anticipated, Saturday’s meeting between President Trump and Chinese President Xi Jinping at the G-20 summit didn’t result in anything close to a comprehensive deal. Yet they agreed to continue negotiating in lieu of imposing higher tariffs, which is itself a positive.
For U.S. stocks to keep rallying, they’ll have to “earn it.” But that task has become more challenging. Analysts began downgrading companies’ earnings outlooks in January. While negative earnings revisions are typical early in the year, analysts began to further reduce their 2019 profits estimates for S&P 500 companies in early May. This timing coincided with President Trump’s May 5 trade-tweet bombshell in which he promised to increase tariffs on $200 billion of Chinese goods, from 10% to 25%, and threatened to impose a 25% tax on an additional $325 billion.
Meanwhile, S&P 500 valuations—expressed as price-to-earnings (P/E) ratios—have climbed this year, from 14.3x earnings in January to 16.7x earnings as of June 28. The rising “P” for price and falling “E” for earnings have made stocks more expensive. While below their most recent peak of 18.1x in January 2018, valuations are well above their 14.9x average over the course of this 10-year bull market.
And valuations may be even higher than they appear. In the second quarter, a near-record number of S&P 500 companies issued negative earnings-per-share guidance. Also, earnings forecasts for 2020 have been declining and might dip further if tariffs begin to bite harder.
That said, we still expect global economic growth, even at a slower pace, to remain supportive of overall demand, and therefore of corporate earnings. Lower earnings growth is not a death knell for stocks, but it does suggest a far flatter trajectory for equity markets in the second half of the year.

U.S. economy: Fireworks on July 4 and July 5?         

Investors always look with anticipation to the first Friday of the month, when the Labor Department releases the prior month’s employment data. But June’s report, due on July 5, seems to be more highly anticipated than most. Perhaps that’s because the U.S. economy added just 56,000 payrolls in February and only 75,000 in May, raising fears that the jobs engine was petering out.      
Consensus estimates are calling for a pickup of 160,000 new positions, with no change in wage growth (+3.1% year-over-year in May) or the unemployment rate (+3.6%). In our view, those levels wouldn’t reduce the market’s call for Fed rate cuts, nor ring the recession alarm, especially if May’s job totals are revised significantly upward.
A major “miss” (of more than 30,000 payrolls either way) could trigger an outsized market reaction, because financial firms and trading desks will be lightly staffed on Friday. With fewer buyers and sellers in the market, there’s a greater chance that big trades will dramatically move prices.
Against that backdrop, here are two potential payroll scenarios:
  • A big downside surprise (job creation of 125,000 or below) would almost certainly drive down Treasury yields. A weaker U.S. dollar would also be likely, as another month of sluggish job growth would raise the odds of multiple Fed rate cuts this year. At the same time, equities might not react much at all. Although stock prices have moved higher recently on hopes for a dovish Fed, one or two cuts in 2019 have already been “baked in.”
  • A big upside surprise (job creation of 200,000 or above) is possible following May’s subpar payrolls report and still-low levels of jobless claims, which reflect a still-healthy labor market. The odds of Fed easing would likely fall under such a scenario, and stocks could suffer. Short-term Treasury yields, which tend to closely follow Fed policy, could rise. 
Wage growth is worth watching. Businesses are still reporting plans not only to hire more workers but also to boost paychecks. In this already tight labor market, even so-so job creation may lead to hotter wage gains—and perhaps convince the Fed to remain on hold.  
To our readers: The next Weekly Market Update will be published on July 15, 2019.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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