11.11.19

Latest trade headlines leave U.S. equities “phased and confused”          

Brian Nick

The last week’s market highlights:

Quote of the week:

“I know that everything comes to an end. Everything is a phase.” – Mustard      
 
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 4Q 2019 Outlook :
 
  • U.S. economy: Still seeing signs of growth
  • Global economy: Downward pressure but no recession.    
  • Policy watch: Markets expect more easing  
  • Fixed income: Opt for high quality, longer maturity  
  • Equities: Get defensive, stay invested  
  • Asset allocation: While cautious, still prefer emerging-market bonds    

Wrapping up third-quarter earnings: Disappointing, not dreadful

First the good news on earnings—and there’s not much as the third-quarter earnings season winds down. According to Bloomberg, about 80% of S&P 500 companies reporting so far have registered upside earnings-per-share (EPS) surprises, by an average of 4.7%.
The bad news? Negative (-1%) year-over-year EPS. And for the fourth quarter, EPS are expected to improve only marginally (+0.6%) compared to last year. It’s true that analysts tend to low-ball earnings forecasts at first, only to raise them over time. Doing so increases the likelihood that companies will generate “earnings beats.” But amid slowing global growth and ongoing uncertainty surrounding the U.S./China trade war, a meaningful year-end bounce in profits is looking less likely.
 
Data released last week helped explain why margins are under pressure. Productivity, a measure of employee output per hour, unexpectedly fell 0.3% in the third quarter. Meanwhile, unit labor costs rose at a quicker-than-forecast 3.6% during the quarter and 3.1% compared with the same period a year ago—the fastest pace in five years.
 
This bottom-line-bruising mix of paying more for less productive employees has been exacerbated by a prolonged stretch of underinvestment. Trade-fueled uncertainty has discouraged businesses from boosting capital expenditures. In addition, firms have been forced to divert resources to less productive uses, such as shifting supply chains out of China.  
 
Despite this unhealthy earnings backdrop, large cap stocks as measured by the S&P 500 have remained in rally mode, advancing 4.1% in the fourth quarter thus far and 25.4% year to date, while notching 19 new record highs along the way. In contrast, similar celebrations have eluded the small cap S&P 600 Index (+19% for the year to date), which has yet to reclaim its most recent peak.
 
What’s behind the small cap struggles?
 
  • A “tiny” bit of tech.  Technology shares, the year’s best performers, are underrepresented in the S&P 600 (14% of the index) compared to the S&P 500 (20%).   
  • Small cap earnings have evaporated in 2019.  Profits of smaller firms declined 9.8% and 5.2% in the first and second quarters, respectively, and are on track to fall almost 6% in the third quarter.  
 
Because of these disappointing earnings, small cap valuations have risen this year, as measured by the price/earnings (or “P/E”) ratio. As things stand for investors, small caps look richly priced even though they’ve underperformed. In our view, their best chance of outperforming in the coming quarters would be in an environment of accelerating economic growth and large upward revisions to corporate profits.
 

U.S. economy: Tariffs fail to dent deficits

Among his campaign promises, President Trump pledged to significantly reduce the U.S. trade deficit, which over the past two decades has ranged from $25 billion to $68 billion per month. (This means the U.S. has been buying more goods and services from other countries than it has been selling to those countries.) So he was probably pleased to hear that the trade deficit narrowed to its lowest level ($52.5 billion) in five months in September.
 
Still, Trump would have a tough time arguing that his aggressive tariff regime has fully addressed the U.S. trade imbalance. When it comes to China—the focus of his trade ire—the U.S. goods deficit did fall by about 25% in the first nine months of 2019, although it’s essentially unchanged since he took office in January 2017. But what the U.S. hasn’t been buying from China, it’s been buying elsewhere—especially from Korea, Vietnam and Taiwan. The end result? Our trade deficit in goods has stayed at about the same level throughout 2019.   
 
Also, the overall deficit for both goods and services in the first three quarters of the year jumped by 5.4%, to $481 billion, from the same period a year ago. The U.S. trade deficit in goods surged throughout the latter half of 2018 to an all-time wide level of $79.8 billion in December as the individual and corporate tax cuts passed in late 2017 boosted U.S. demand for imports (and almost everything else).
 
Trump often portrays the U.S. as “losing” because of its consistently large trade deficits. But such deficits are neither a sign of economic weakness nor an indication that the U.S. is being taken advantage of, as he suggests. Trade balances are determined by relative savings rates. The U.S. is a massive, growing economy with a relatively low savings rate (public and private), which means it will tend to run a large trade deficit. Investors in other countries are happy to finance that spending and use the dollars we pay them for imports to buy financial assets ranging from Treasury bonds to small cap stocks. This capital account surplus will, by definition, fully offset the current account deficit we run by importing more than we export.
 
The dollar’s rise since late 2017 has made imports cheaper, encouraging the deficit to move higher. The more muscular greenback is due in large part to higher yields on U.S. Treasuries versus their developed market counterparts and the strong return of U.S., both of which have attracted capital stateside over that stretch.         
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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