The last week’s market highlights:
Quote of the week:
“I must say to you that the state of the union is not good.” - President Gerald Ford
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2019 Outlook :
- U.S. economy: A slowdown, not a recession
- Global economy: Amid lower expectations, emerging markets could surprise to the upside
- Policy watch: Fewer tailwinds, stronger headwinds
- Fixed income: Rates likelier to rise than fall
- Equities: Late cycle but good value
- Asset allocation: A neutral stock-bond view
“No-mentum” in the global economy
Heading into 2018, economic news worldwide was broadly positive. Indeed, in its October 2017 outlook, the International Monetary Fund noted that “economic activity is strengthening,” fueled by “notable pickups in investment, trade, and industrial production, coupled with stronger business and consumer confidence.”
Not so fast. It turned out the global economy had ideas of its own, decelerating throughout 2018 and beginning the new year without fresh momentum. This was demonstrated by broad weakening in growth, as measured by Purchasing Managers’ Indexes (PMIs) and similar gauges of economic output. The JPMorgan Global Composite Output Index, for example, fell in January to its lowest level (52.1) since September 2016. While this reading was still above the 50 mark separating expansion from contraction, the pace of manufacturing and service-sector activity declined dramatically last month, weighed down by a slump in new business orders.
The deceleration in PMIs has been occurring in both developed- and emerging-market (EM) economies. EM manufacturing dipped into contraction territory (49.5) last month, due mainly to poor performance in China. Small- and medium-sized Chinese companies, key sources of growth and jobs, struggled. Meanwhile, Brazil and India were relative standouts in terms of EM economic results in the fourth quarter of 2018, and even their PMIs merely held steady.
Major developed economies also stumbled in January. Composite PMIs eased in the eurozone, Japan, and the U.K. One consolation: all three readings stayed in expansion territory, albeit marginally.
Better economic news came from the world’s largest growth engine, the U.S. Solid levels of service-sector and manufacturing output (54.4) were supported by buoyant job growth and improved business optimism.
Against this backdrop, what are the implications for investors?
- Already-low interest rates are likely to stay low. The bellwether 10-year U.S. Treasury yield closed at 2.63% on February 8, down 7 basis points (0.07%) for the week and 61 basis points from its November 2018 multi-year high of 3.24%. Overseas, Germany’s 10-year bund, after peaking near 0.60% in October, fell to 0.09% by week’s end—still a rich payout compared to that offered by Japan’s 10-year security, which hasn’t topped 0% since January 24.
- Cyclical sectors may lose their edge. In the U.S., economically sensitive sectors such as Industrials and Energy raced out of the gate past more defensive areas like Health Care, Consumer Staples, and Utilities. Such outperformance is consistent with tailwinds provided by rising global growth and higher commodity prices. However, that’s not the environment we expect for the rest of 2019. In our view, some of the “cyclical bounce” since the beginning of the year is the result of investors’ pricing out December’s acute recession fears.
- Policy obstacles like Brexit and the U.S.-China trade dispute could magnify market risk. We saw a double dose of this in equity markets last week: The U.K.’s FTSE 100 Index tumbled 1.1% (in local terms) on February 7 as the Bank of England warned that a no-deal Brexit could sink the U.K. into recession. On the same day, the S&P 500 lost 0.9% after the White House confirmed that President Trump and Chinese President Xi Jinping would not meet before March 1, when tariffs on $200 billion of Chinese goods are scheduled to jump from 10% to 25%.
The question is whether and where some upbeat economic headlines might emerge. While central bank tightening is already coursing through the relevant channels in the U.S. and, to a lesser extent, the eurozone, the effects of easier monetary policy in China have begun to kick in. As they do, we think assets tied to a rebound in China—namely, EM equities, currencies, and credit—could benefit.
Sound familiar? It should. We outlined this theme in our 2019 Outlook, written just three months ago. January’s equity bounce back and Beijing’s policy efforts notwithstanding, we think investors will feel the wind in their faces for much of the balance of the year, even if it won’t blow them significantly off course.
“Slow-mentum” for U.S. earnings
With 67% of S&P 500 companies reporting through February 8, year-over-year earnings for the fourth quarter of 2018 have grown a more-than-respectable 14.3%, according to Bloomberg data. Sales are up a solid 6.5%. But earnings “beats” have been occurring less frequently compared to the previous quarter, and the magnitude of the average upside surprise has been barely half of that generated in the last three quarters.
Most importantly, estimates of earnings-per-share (EPS) growth in 2019 and 2020 have been declining steadily. Although such downward revisions are fairly common, this year’s drop is a bit troubling, as it has taken place amid weaker global growth and heightened policy uncertainty. The latter includes U.S.-China trade tensions, Brexit, and, possibly, a second U.S. government shutdown unless Congressional Republicans and Democrats reach an agreement on border security by February 15.
In fact, we expect negative EPS revisions to persist throughout 2019, creating additional headwinds for U.S. equities. Meanwhile, EM stocks have kept pace with the S&P 500’s 8% year-to-date return and may be poised to advance further, for three reasons:
- First, valuations in the developing world are more attractive than they are in the U.S. As of February 8, the price-to-earnings (P/E) ratio for the MSCI Emerging Markets Index sits at 11.7, close to its 10-year average of 11.3, versus 15.8 for the S&P 500, further above its 10-year average of 14.9.
- Second, in contrast to the U.S., which is in the late innings of its economic cycle, many EM countries are in the early (Brazil, South Africa) or middle (Egypt, India) stages of theirs. This means their economies have greater potential to shift into higher gear.
- Third, EPS estimates for EM stocks have already been knocked lower and are beginning to edge up.
A quiet yet powerful rally in EM currencies, led by the Brazilian real, Russian ruble, and South African rand has supported EM equity performance this year. We’ve also seen a lengthy pause and partial reversal in the devaluation of the Chinese yuan. In our view, EM currencies could continue to perform well, especially if the Fed remains patient in raising interest rates. That’s because lower rates stateside tend to keep a lid on the U.S. dollar’s ascent. Stronger local currencies, in turn, make it easier for EM companies to service, roll over, and repay dollar-denominated debt.