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Markets at record high, but risks remain

MAY. 06, 2019
  • Markets rose last week, with the S&P 500 Index finishing at a fresh weekly high. Through April, the S&P 500 returned 18%, which is the best start to a year since 1987. This is only the fifth time in the past 70 years that growth has been above 15%. This has not been a particularly good omen, as the average return of those years between May and December was -8.1% including a 14% decline in 1987. On the other hand, it is the 16th time since 1950 that the first four months of the year were positive with the average performance for the rest of the year at +10%. We now enter the seasonally weak month of May and face some interesting challenges.
  • The economy appears to be in a “goldilocks” period, with improving growth metrics but tame inflation. Job growth in April was better than expected, and the three-month average is higher than the average for the current economic cycle. The unemployment rate is at the lowest level since 1969 at 3.6%. Wage growth is steady at 3.2% despite the fact that there are more jobs available than unemployed people to fill them. Productivity data surprised to the upside with 2.4% growth from a year ago – the best reading in nearly a decade. Despite the encouraging economic data, benign inflation data has the Fed on the sidelines. At the FOMC meeting last week, Chair Powell stressed that it remain data dependent, with the balance of risks reasonable even between upside and downside.
  • This week will be a test of how much positive news is baked into the strong year-to-date move for stocks. President Trump tweeted over the weekend that he will increase tariffs on Chinese goods from 10% to 25% on $200 billion of goods on Friday and threatened a 25% tariff on $325 billion in additional imports in response to slow trade talks. There were reports that an agreement was imminent with talks scheduled this week, and markets could see a 2% decline in response (China down 5+% on the news). There was concern that the threats could have derailed those talks, though the Chinese delegation is still planning to attend. This rhetoric is likely a negotiating tactic, as similar threats have been used in the recent past, but the market reaction is an indicator that markets are unprepared for a failure in talks.
  • Interest Rates: Similar to trade talks, investors may be too optimistic with respect to the direction of Fed policy. In last week’s FOMC statement and during the subsequent press conference, Chair Powell gave a balanced view of policy, stressing that the board will be patient given the balance of risks. Economists share this view in surveys, with 63% of respondents expecting a cut through the end of next year. However, markets are asymmetric in their expectations. The Fed futures curve embeds a 56% chance of a cut this year and an 80% chance of a cut through next year, with a 0% chance of a hike. Investors initially sold on the Fed commentary last week, viewing it as incrementally hawkish, but that fear quickly faded and markets rallied to new highs.
  • Earnings: With nearly 80% of the S&P 500 companies having reported earnings, 76% have beat earnings estimates and 60% beat sales estimates, both above the long-term average. Earnings are on pace to fall 1% from a year ago, which is better than the -4% expected a month ago, while sales are set to grow more than 5%. For the second quarter, earnings are estimated to be -1% on 4% sales growth. Six months ago, the expectation was for 6% earnings growth.

What to Watch

  • Following a very active week, the economic news is a bit light next week, highlighted by consumer credit and job openings (JOLTS) on Tuesday, producer price inflation on Thursday and consumer price inflation on Friday.

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