The last week’s market highlights:
Quote of the week:
“The Eagle has landed.” – Neil Armstrong
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
Are consumers up for double duty by lifting earnings and second-quarter GDP?
Perhaps the biggest tipoff that challenging times may await U.S. equities is the frequency with which “looming” has been used to describe the second-quarter earnings season, which began in earnest last week. One year ago, profit margins were being boosted by large tax cuts and stronger-than-expected U.S. economic growth. Today, without a similar fiscal catalyst and the economy grappling with the uncertain effects of U.S. protectionist trade policy, the outlook for earnings is murkier. Indeed, S&P 500 company earnings rose just 1.4% in the first quarter and thus far are averaging just 2.1% for the second quarter. While we may avoid a rerun of the “earnings recession” of 2015-16, when earnings were negative for six straight quarters, this weakness is likely to persist into the second half of the year.
Fortunately, amid sluggishness in manufacturing data and weaker business investment, consumers have acted as a powerful economic anchor. On the heels of healthy consumer spending in April and May, retail sales popped 0.4% in June¾their fourth straight positive month. Even better news: The so-called retail sales “control group,” a subset of the headline number that excludes volatile components such as automobile and gasoline sales, and is used to calculate GDP, jumped 0.7% last month and 7.4% (on an annualized basis) for the second quarter as a whole. As a result, we believe consumer activity will add more to second-quarter GDP than it did to first-quarter GDP. (The government’s advance estimate is scheduled for release on July 26.)
What’s behind the glide in consumers’ stride? A number of tailwinds, such as:
- Unemployment at a multi-decade low
- Wages increasing at a 3%+ annual clip
- Solid household balance sheets, bolstered by a 6%+ savings rate
- Rising stock and home prices
Against that sturdy backdrop, consumers have been driving some better-than-expected earnings reports lately. Global banks, including Bank of America, JPMorgan Chase and Citigroup, all posted second-quarter earnings that reflected strong consumer borrowing. Consumer-focused regional banks such as PNC Financial Services and U.S. Bancorp also delivered sizable profits.
And it appears consumers may be prepared to keep of propping up the economy. A preliminary reading of July’s University of Michigan consumer sentiment index, released last week, hovered near a 15-year peak. Although survey respondents were somewhat less upbeat about their own financial situation and the current state of the economy, they think conditions will improve over the next six months.
Policy watch: It’s no longer if, but how big.
As recently as May, investors asked “Will the Fed cut interest rates this year or not?” By now, the debate has shifted, to “They will. But by how much?”
To be sure, all signs point to the Federal Reserve’s lowering interest rates on July 31. Such a move would be the Fed’s first since the financial crisis in 2008. We question the need for a rate cut given the economy’s generally solid performance in the second quarter. In fact, the economy appears to be gaining momentum heading into the third quarter, evidenced by June’s positive economic data, which include:
- Robust retail sales growth.
- Healthy job creation and wage gains.
- Hotter-than-anticipated core inflation.
Admittedly, though, June flashed a few warning signs:
- The Conference Board’s index of leading economic indicators fell.
- Despite lower mortgage rates, housing starts slumped. And building permits—a forward-looking indicator—also declined.
With the Fed’s dual mandate—price stability and full employment—close to being fulfilled, Chair Jerome Powell and his colleagues have been pointing to trade uncertainty, weaker global growth and policy risks (including Brexit and the looming U.S. debt ceiling debate) to justify a potential rate cut.
How might markets react if the Fed were to take the plunge?
- U.S. stocks would likely remain well supported as investors seek alternatives to low-yielding Treasuries and municipal bonds. (This phenomenon is known as the “TINA” principle—as in “there is no alternative” to equities.)
- The Treasury yield curve would steepen. Long-term yields could edge up amid the ongoing economic recovery while short-term yields, which are more sensitive to Fed policy, decline.
- The dollar would probably weaken little, if at all. The greenback tends to lose value against other currencies when the Fed lowers rates and other central banks hold them steady (or tighten). This time, though, central banks globally are already in easing mode, which is likely to cause the currencies of their respective countries to fall. Moreover, major developed-market sovereign bonds, such as those issued by Japan and Germany, are currently offering negative yields, thus making U.S. Treasuries the “best game in town.” (High demand for Treasuries supports the dollar.)
Although the market-implied odds of a July rate cut are at 100%, investors still tuned in to last week’s heavy dose of “Fedspeak” to gauge whether the scope of the cut will be 25 or 50 basis points. On July 18, two senior Fed officials—Vice Chair Richard Clarida and New York Fed President John Williams—extolled the virtues of cutting rates quickly and decisively to counter early signs of disinflationary pressure. On cue, markets reacted, well, quickly and decisively. Stock prices rose and Treasury yields fell as investors interpreted the speakers’ words to mean the bigger, 50-basis-point reduction, may be on tap. (We view such action as unlikely.)
For the rest of the month, investors will have to devise their own methods of reading the monetary policy “tea leaves.” That’s because starting July 22, the Fed enters its “blackout period” that precedes every policy meeting. All will be quiet on the central bank front until Powell announces the July rate decision and takes questions from the press.