On July 31st Fed Chairman Jerome Powell cut US interest rates for the first time in a decade, an about turn after seven interest rate rises since 2015. He followed this up with a further 25bps cut in September. Powell senses some economic weakness but no recession seeing the outlook as ‘still favourable’ and the cuts as an ‘insurance policy to sustain the expansion’ in the face of an expected further slowdown in the momentum of global growth, muted inflation, and in particular the threat to growth from the trade conflict.
US consumer confidence is currently at highs last seen in 2000 but the ISM manufacturing new orders number is below 50, signalling a contraction in economic activity with new orders at their lowest level since 2009. This pattern is following the classic late cycle global trend of weak manufacturing/strong consumer. The overall US GDP numbers show few signs of cracking thus far though with unemployment at multi-decade lows, core CPI (ex food and energy) rising to 2.4% and wage growth at 3.2%.
The US bond market is taking a far more pessimistic view, signalling recession with a collapse in yields at the long end of the curve and an overall curve which is flirting with inversion (i.e. 2 year yields are higher than 10 year yields). This is seen as the most reliable of recession indicators, though often with a considerable lag of up to a year. It is however an election year in 2020 and Trump will be doing his very best to prop the numbers up one way or another.
The US is in earnings recession. For Q2 2019, the blended earnings decline for the S&P 500 was -0.4% with estimates for Q3 being -3.7% this would be the first time that the index has reported three straight quarters of year-over-year declines in earnings since Q4 2015 through to Q2 2016. This reflects the effects of the margin squeeze of rising labour costs coupled with the effect of a strong dollar and trade war hurting the huge US multi-nationals. Estimates are for a 3% rise in Q4 earnings which aggregates a very small increase in earnings of 1% for 2019 as a whole. Once we reach 2020 the y/y bar is much lower and forecasts are for 10% earnings growth in the rather optimistic way analysts seems to have.
Notwithstanding the ‘bounce back’ element after the collapse in Q4 last year, the equity market has defied economic and political concerns with the S&P 500 now having risen by an eye-watering 20% this year and standing around all-time highs. The strong market means that valuations are no longer supportive with the market trading on a rather pricey forward P/E of 17x making it more vulnerable to negative news flow.
Summary. Equity markets continued to produce strong returns but a slowing economy, falling earnings estimates and a relatively rich valuation suggest little further upside and more volatility for the rest of the year.
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