Markets pull back as reality disappoints versus expectations
AUG. 05, 2019
Equity markets had their worst week of the year as investors adjust to a more neutral Fed than expected and an acceleration in the trade war with China. The S&P 500 hit an all-time high on July 26 as investors embedded optimistic expectations but has traded sharply lower since. Volatility has returned, with the VIX above 20 for the first time since May.
As expected, the FOMC cut rates by 0.25% to 2.00-2.25% last week citing “implications of global developments for the economic outlook as well as muted inflation pressures” in its first rate cut since December 2008. While they left the door open to future cuts by saying it will “act as appropriate to sustain the expansion,” investors read a less dovish tone than expected. Fed Chair Jerome Powell noted that the cut was simply a “midcycle adjustment” and that the committee did not see the type of marked economic weakness that would necessitate a longer rate-cutting cycle. Despite the tone, the Fed Futures curve embeds a 100% chance of an additional cut at the September 19 meeting (15% chance of 0.50%) and an 85% chance of an additional cut (three total) by the end of the year. There continues to be a clear disconnect between the guidance of the Fed and the expectations of investors.
Also last week, President Trump announced the intention to impose additional tariffs on the remaining $300 billion in Chinese imports that have to date been untouched on Sept. 1. This came after USTR Lighthizer and Treasury Secretary Mnuchin told him they did not secure any specific guarantees in the latest round of trade talks with China. This would break the truce that was agreed to at the G-20 meeting. Over the weekend, China asked state-owned companies to suspend imports of U.S. agricultural products in retaliation. While the new phase of tariffs would only account for 0.14% of GDP, it is a signal to investors that the trade war is far from over. China also devalued the yuan, which currently trades at a record low versus the dollar. This mirrors the 2015 devaluation that led to worries over global deflation and a sharp pullback in equity markets. U.S. imports from China fell 12% in the first six months of 2019, while exports fell 19%, below both Mexico and Canada for the first time since 2005.
Second-quarter earnings continue to surprise to the upside, with 76% beating earnings estimates and 59% reporting a positive revenue surprise. The blended rate, however, is tracking towards -1%, which would be the first back-to-back declines since 2016. The uncertain global growth environment and the dollar are the primary headwinds, affecting globally-focused sectors such as Energy, Materials, Industrials and Technology. Estimates have been revised lower for the third quarter, with a current estimate of -2%, which would be the third-straight negative quarter. Analysts currently expect a rebound in the fourth quarter to +5% and +11% last year, though this would require a stabilization in global manufacturing and the dollar. Continued downside adjustments would be a headwind for equity markets.
The job market remains robust, with July registering the 106th consecutive month of gains with 164k. The unemployment rate remains at a 50-year low of 3.6%, and wage growth remains healthy at 3.2%. The manufacturing economy is weaker, and with a sharp global slowdown and escalating trade war with China, the economy is vulnerable. The current estimate for third-quarter growth is 1.9%, down from 3.1% in the first quarter and 2.1% for the second quarter.
Details on Performance
The sell-off was broad-based last week, with large caps, small caps, growth, value and developed international all lower by roughly 3%. Safe-haven sectors of real estate, utilities and health care led, while technology, financials and communication services lagged.
Interest rates continue to fall, with the 10-year Treasury yield below 1.8% on Monday for the first time since before the 2016 election.
What to Watch
Economic data will be in focus next week, with PMI and ISM reports on Monday, JOLTS job openings on Tuesday, consumer credit on Wednesday and Producer Price Inflation on Friday.
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