Equity markets continue their march higher, with the S&P 500® Index rising in five of the past six weeks to crack 3,000 for the first time. That period has a consistent theme, with markets grinding higher on Fed optimism, despite sluggish economic data and lack of concrete progress in China trade talks.
The Fed continues to be the primary driver of market movement, with Congressional testimony from Chair Powell and the minutes for the June FOMC meeting reinforcing investors’ belief that a rate cut is coming on July 31. There is a 100% chance of a cut embedded in the curve for July, with a 28% chance of two cuts. This is despite readings on PPI and CPI last week that were hotter than expected. With expectations so set on a cut, last week was the last opportunity for Fed officials to tamp expectations, and they did not do so. A failure to cut would be a tremendous shock to equity investors and undoubtedly lead to volatility. The balance of risks seems to the downside around the meeting, as the chances of disappointment outweigh the upside.
Earnings season ramps this week, led by banks and technology companies, providing a clearer picture of the challenges facing companies in this environment. To date, 88 companies in the S&P 500 have warned that their second quarter results will disappoint, equaling the second-largest number with negative guidance since 2006. The current consensus is for a decline in earnings of 3% despite sales growth of 4%. This would be the second-straight negative quarter of growth, signaling a technical earnings recession. Analysts and management guidance tend to be the most negative just before the announcement, resulting in upside to estimates of nearly 3%, suggesting that the quarter may be flat to positive. The third quarter is also currently expected to decline before a rebound in the fourth quarter and next year. A rebound in earnings is critical to continue to strong equity market, as the forward P/E has risen above 17x.
With the political divide continuing to be wide in Washington, Congress faces a looming budget battle and the reality that the debt ceiling will likely be breached in September. There is little time for an agreement before the August recess, and if the limit is breached without an agreement, sequestration will be triggered. Republicans want to tie the vote to a broader budget deal, but there is little agreement between the sides on how that would look. There was a similar fight in 2011 during the Obama administration, and the S&P 500 dropped 13% in three weeks.
There was little progress in trade negotiations with China, with news reports that the same issues that derailed talks two months ago remain, including details on purchases of agricultural and industrial products, enforcement of intellectual property and the timing of tariff removal. China GDP slowed to a 27-year low of 6.2% in the second quarter, though appears on track to hit the 6.0-6.5% guidance for the year. Industrial production and retail sales rebounded in June due to incremental stimulus, though the trade overhang remains.
What to Watch
Conference calls following earnings releases will signal the direct impact from the global slowdown and trade tensions. Economic data includes retail sales and industrial production on Tuesday, housing starts and the Fed’s Beige Book on Wednesday, leading indicators on Thursday and consumer sentiment on Friday.
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