Equity markets fell slightly last week on continued worries over the escalated trade war with China. Markets followed the worst week of the year two weeks ago with the worst day of the year on Monday, with a recovery through the week. Despite the S&P 500 Index trading only 5% below an all-time high, institutional and retail investor sentiment reflects a substantial bearish shift.
The challenges facing China go well beyond trade, with protests in Hong Kong forcing the grounding of all flights on Monday as thousands of demonstrators filled the airport to protest for their handling of this summer’s protests. This weekend was the most violent of the 10-week conflict, and there is no sign of ending tensions in the semiautonomous Chinese city. The trade dispute also shows no signs of imminent resolution, as there is growing speculation that China will push out an agreement to beyond November 2020 in hopes that they are negotiating with a different administration.
Worries over global growth intensified last week, driven by a break-out low in the Chinese yuan that brought the prospect of a currency war within view. Three global central banks (New Zealand, India and Thailand) cut rates, driving the total of negative yielding global debt to more than $15 trillion. The drop in the U.S. 10-year to the lows since before the 2016 election has some speculating on the possibility of negative domestic rates. This could increasingly push investors towards equities, as the yield on the S&P 500 exceeds that of the 10-year Treasury by 0.4%, and more than half of the S&P 500 stocks have dividend yields above the 10-year.
While geopolitics and trade dominate the headlines, the critical factor in equity markets is the outlook for corporate earnings. The second quarter looks like it will be the second-straight negative quarter for earnings, with the third quarter currently forecasted to decline. Domestic results have been positive, though sectors with foreign exposure are declining due to weak revenues and margin contraction. Currently, earnings are expected to rebound to growth in the fourth quarter before growing at double-digits in 2020. If estimates begin to be meaningfully revised lower for 2020, current valuations will come under scrutiny.
Investors remain convinced that the Fed will remain stimulative through the current period of uncertainty. The Fed Futures curve currently embeds a 100% chance of a cut at the September 18 meeting (17% chance that it is 0.50%), and a near-50% chance of a total of four cuts to the Fed Funds rate by year end. This is substantially more dovish than comments by Fed officials would suggest. The PPI reading last week showing core producer inflation falling for the first time since early 2017 supports that belief, as benign inflation will be critical to justify additional rate cuts.
The negative shift in investor sentiment is being mirrored by increasing pessimism among economists. A Reuters poll revealed a median 45% probability of the U.S. economy slipping into a recession in the next two years, up from 35% in the previous poll and the highest since that question was first asked in May 2018. Nearly 70% of economists said that the escalation in the trade war brought the next recession closer.
The selling last week was modest, with growth outperforming value and large beating small. Year-to-date, the strongest style box is midcap growth (+27%) and the weakest is small value (+9%). International markets lagged domestic last week and the year. Bond indexes were helped by the falling rates, though widening credit spreads were a headwind for high yield.
Investors continued their dramatic shift from equities to bonds, with $25 billion in outflows from equity funds and ETFs in the most recent week, with government debt and money markets adding $102 billion.
What to Watch
Economic data next week will be highlighted by CPI on Tuesday, perhaps signaling the next move by the FOMC. Additionally, the NFIB Small Business Index is released Tuesday, import and export prices on Wednesday, retail sales and industrial production on Thursday and housing starts and consumer sentiment on Friday.
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