“Exploring the unknown requires tolerating uncertainty.” ― Brian Greene
Volatility spiked at the beginning of October and U.S. stocks have continued to make limited headway. In fact, the S&P 500 is less than 2% above the initial peak on January 26, 2018. A meaningful breakout to the upside has been mired by the short-lived reprieve from trade worries; as investors remain hesitant due to conflicting reports from this week’s trade talks in Washington and recently-renewed tensions. Further, the manufacturing sector’s deterioration in September (along with some notable weakness on the services side), dysfunction in Washington, and ambiguity regarding monetary policy have kept stocks within a tight trading range. As was confirmed last month, the strength in large-cap, momentum, and low volatility strategies has been sustained; along with defensive stocks’ continued sprint ahead of their cyclical peers. This has coincided with key defensive sectors’ positive earnings growth expectations for the third quarter. Yet, S&P 500 earnings are expected to decline by more than 3% year-over-year as per October 10, 2019 Refinitiv data. Although only a small fraction of S&P 500 companies have reported, so far the vast majority have beaten expectations thus far; but we are keeping a close eye on mentions of headwinds due to trade.
When bad news becomes good news
U.S. stocks slipped at the beginning of October on the heels of the ISM Manufacturing Index’s deeper fall to 47.8, and the Non-Manufacturing Index’s drop to 52.6—the former again below 50, marking contraction; and the latter above, marking expansion. Breadth among both surveys’ components was weak, and notably, Non-Manufacturing’s employment component fell to 50.4—the lowest since February 2014. You can see from the charts below that employment has suffered markedly in both sectors; and if manufacturing continues its downtrend, it could pull services into contractionary territory.
Manufacturing Has Remained In Contractionary Territory…
Source: Charles Schwab, Bloomberg, as of 9/30/2019.
…Which Has Started to Pull Down Non-Manufacturing
Source: Charles Schwab, Bloomberg, as of 9/30/2019.
Some panic ensued after the reported weakness in manufacturing; and, although the same held true after the initial release of the services data, stocks quickly reversed course. Investors renewed their hope for a rate cut at the next Federal Open Market Committee (FOMC) meeting later this month—odds of an October cut have surged over the past couple weeks and are just over 70% as of October 10, 2019. As has been proven by the lack of positive breadth in recent economic data and subdued consumer and even weaker business confidence, we continue to believe rate cuts are not the full elixir for what ails the economy. Minutes from the September FOMC meeting confirmed that officials remain divided on the outlook for monetary policy—with some noting that the market may be expecting too much easing and needs to realign its expectations. Yet, there has been persistent emphasis on the risks that the trade war, Brexit, and disruption in Hong Kong pose to the economy.
Follow the leader, not the laggard
Further bolstering support for an October cut was September’s jobs report, which showed an increase in nonfarm payrolls of 136k, missing consensus estimates by 9k. Yet, the prior two months were revised up by a total of 45k jobs and the unemployment rate edged down to 3.5%. Many have cheered the unemployment rate’s fresh 50-year low, but we want to remind investors that, when it comes to employment data, the unemployment rate is the most lagging indicator of future economic activity. Whereas initial unemployment claims (which have flat lined of late) are considered one of the more leading of employment data points; payrolls are generally coincident indicators, reflecting current economic activity; while the unemployment rate is typically the last component to spike.
A quick rise in claims is usually the first “tell” that the economy is approaching a major slowdown; and although claims remain historically low, we have started to see a meaningful increase in some manufacturing-oriented states. The following list shows the states with the largest upticks in the four-week average of claims (in parentheses) from the January 2018-to-date troughs through September 28, 2019 (the most recent week of data). DC has been and remains an outlier, likely due to its recent minimum wage hike:
West Virginia (43%)
North Carolina (27%)
The aforementioned weakness in both ISM employment components confirms that further slowing in economic data may start to impact hiring sooner rather than later. Keeping the current pace of hiring may be a tall order. As you can see from the chart below, employers will need to churn out, on average, 107k jobs per month to keep the unemployment rate at 3.5% throughout the next year. If payroll growth continues to weaken, it should be expected that the unemployment rate would begin to tick higher.
Strong Payroll Growth Is Needed to Maintain Current Unemployment Rate
Source: Charles Schwab, Department of Labor, Federal Reserve Bank of Atlanta, as of 10/4/2019.
Shifting attention away from the still-healthy payrolls number and low unemployment rate, “private labor earnings growth” has definitively rolled over since last year. The index shown in the chart below is a product of the year-over-year % change in payrolls, average hourly earnings, and average weekly hours. As you can see there has been a steep drop from the October 2018 high of 5.7% to 4.2% in September. As this trend matches that of both ISM employment indexes, it shows that there may be some overlooked cracks underneath the employment surface. [Take a closer look at the jobs situation in Welcome to the Working Week].
Labor “Earnings Growth” Has Fallen Over the Past Year
Source: Charles Schwab, Bianco Research LLC, Bloomberg, Bureau of Labor Statistics, as of 9/30/2019. Private labor earnings growth represents product of y/y % change in private payrolls, average hourly earnings and average weekly hours.
Peak optimism may be behind us
Though trade tensions have recently escalated after a couple quiet weeks, uncertainty has persisted throughout the business community. In September, the Small Business Optimism Index—released by the National Federation of Independent Business (NFIB)—fell to 101.8, with none of the index’s components advancing. You can see from the chart below that the overall index and plans for hiring are both off their August 2018 highs and have failed to break out to the upside. Undoubtedly, trade has taken a toll on small business confidence; as 30% of companies reported negative effects from tariffs; and business owners affirmed that major spending commitments have been put on hold until the future becomes more certain. However, employers haven’t yet cited the trade war as the direct culprit of slower hiring; with the majority still pointing to a shrinking pool of qualified labor.
Main Street Optimism Is Fading
Source: Charles Schwab, Bloomberg, National Federation of Independent Business (NFIB), as of 9/30/2019.
Risk to global earnings
The tit-for-tat tariff escalation between the United States and China began on April 2018, as China responded to U.S. tariffs on steel, aluminum, washing machines and solar panels by imposing 25% tariffs on 128 U.S. products. The following month marked the beginning of a 15-month slide for the global manufacturing purchasing managers’ index (PMI)—the longest slump in the index’s history. This coincided with lower global earnings forecasts, as you can see in the chart below. The current pace of downward revisions to estimates has only been exceeded during the recessions of 2001 and 2008-09.
Analysts’ Earnings Outlook is Tracking the Manufacturing Slump
Source: Charles Schwab, Factset data as of 10/8/2019. Global companies defined as members of MSCI World Index
With only 41 of the 1,650 companies in the MSCI World Index having reported, third quarter earnings seasons is still in its infancy stage. Yet, it is interesting to note that while the consensus estimate for earnings this quarter is a -5% year-over-year decline, early results show that 69% of companies have exceeded analyst estimates. As such, the current positive earnings surprise of 5% may offset the expected -5% decline and mark another quarter of flat earnings per share for global companies.
Though analysts’ earnings forecasts have been falling, they still portend a rebound in future quarters—highlighting further downside risk to earnings estimates that may disappoint investors. Where are estimates for earnings most vulnerable? Remarkably, earnings growth expectations are quite similar across the United States, Europe, and Asia at 10.99%, 10.43%, and 10.32%, respectively; as you can see in the chart below. Thus, risks are present but may be spread equally among these regions.
Similar Earnings Outlook Across Regions
Source: Charles Schwab, Factset data as of 10/8/2019. Indexes used from left to right: S&P 500, MSCI Europe Index, and MSCI AC Asia Index.
However, there are sectors that appear more vulnerable than others to an ongoing slowdown. The global sectors with the highest earnings growth expectations for 2020 are energy, materials and industrials, as you can see in the table below. These are closely tied to manufacturing, suggesting investors are pricing in a rebound in the PMI.
Earnings Outlook for Three Sectors Especially Vulnerable to Manufacturing Slump
Source: Charles Schwab, Factset data as of 10/9/2019. Factset-tracked analyst consensus growth rate from one year ago for companies in MSCI World Index
Without a revival in manufacturing (which is unlikely as long as the trade war continues) these estimates still have downside risk; as stocks face resistance when earnings are not contributing to gains. The MSCI World Index has been unable to break out to the upside since near the start of 2018, as you can see in the chart below.
Global Stocks Have Been Unable to Break Out to the Upside for Nearly Two Years
Source: Charles Schwab, Bloomberg data as of 10/9/2019.
Without signs that earnings may rebound, global stocks may continue to struggle to make gains. This quarter’s earnings calls will likely be packed with commentary on the impact of trade tensions on business confidence and investment. While a trade breakthrough would help lift stocks, ongoing tensions and uncertainty may suggest the trend in earnings revisions remains to the downside.
Volatility has resurfaced due to a revival in trade tensions, heated political fighting in Washington, and confusion over whether the Fed will continue to ease or hold off on rate cuts later this month. Stocks have dropped back into a tight range and have still yet to breach their all-time highs. With the market still highly reactionary to major headlines and struggling to find its footing, we continue to recommend that investors stay near their long-term asset allocation. We also continue to recommend using volatility as a means of rebalancing; and maintaining a bias toward large-cap stocks at the expense of small caps. So long as myriad uncertainties continue to mount, we believe stocks will remain under some pressure and headway will be limited.