Equity markets extended their winning streak to five weeks, with all major indexes closing at record highs. The breakout was driven by fundamental factors, including improving global economic confidence and better-than-expected earnings. A fundamental breakout is preferred to one driven by hope (i.e. trade news, Fed action).
Investor sentiment and behavior is reacting to this breakout much differently than recent ones. The CNN Fear & Greed Index registered “extreme fear” (<25 on a scale from 0-100) in August but is now in “extreme greed” (91), indicating we may have gone too far too fast. Equity funds and ETF inflows were at their highest level in nearly two years. Institutional cash levels remain quite high at $3.5 trillion (highest level since the financial crisis), suggesting a shift in sentiment could push markets higher. A notable headwind for future returns is valuation, with the S&P 500 trading at 17.5x forward earnings for the first time since February 2018.
Investor optimism is also evident in the movement of the yield curve in recent weeks. Last week saw a dramatic steepening of the yield curve resulting in a normal-shaped (un-inverted) curve. The 10-year yield jumped 0.42% since August, showing the largest three-month jump in three years. The spread between the 10-year and 2-year was negative as recently as September is now approaching the widest level in a year. As a result, the odds of a FOMC rate cut have collapsed to just 5% in December and 33% by next June (was 63% a month ago). Fed Chair Powell’s testimony will be closely watched this week, though unlikely to materially diverge from comments made following the October meeting. The market strength in the face of fading rate cut odds is encouraging.
Officials in China and the U.S. continue to express optimism on the direction of trade talks, though there are few concrete commitments or an agreed timetable. Conventional wisdom had suggested that lack of an agreement before the December 15 tariff escalation would be catastrophic for equities, though recent strength despite deal details, perhaps, indicates that markets are less sensitive to deal news.
Earnings season has largely concluded, with blended earnings growth of -2% on +3% sales growth. This is the third-straight quarter of declines, and the current outlook for fourth quarter is for flat growth. While the absolute level of growth was negative, the reaction to reports was encouraging, suggesting sentiment had become overly negative. Companies that disappointed versus estimates had below-average declines in reaction, while companies that beat had their best gains since 2014.
While too early to declare victory, there are initial signs of a stabilizing global economy. Domestic growth continues to be slow, but steady, driven by the strength of the consumer and the job market. Recent data in Europe shows that the U.K. and Germany are seeing stability despite continued Brexit uncertainty. The Emerging Market economies continue to drive global growth, with the IMF forecasting 3.0% global growth in 2019 and 3.4% in 2020.
What to Watch
President Trump is scheduled to speak at the Economic Club of New York on Tuesday, while Fed Chair Powell speaks to Congress on Wednesday. Inflation data takes center stage, with CPI on Wednesday and PPI on Thursday. Other notable data releases include the NFIB Small Business Index on Tuesday, and retail sales and industrial production on Friday.
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