For the week ending November 1, 2019
This publication is provided by BMT Wealth Management.
Stocks Reach New Highs as Key Economic Data Signals Stability
Last week we received important data linked to the labor market and the manufacturing sectors. Slowing jobs growth and weakening global manufacturing have been widely cited by market-bears as key evidence that record stock market highs would be short-lived. Recent economic data supports a different, less negative, forecast.
In our view, both the October non-farm employment report and the Institute for Supply Management’s (ISM) Manufacturing Purchasing Manager’s Index (Manufacturing PMI) provide evidence that the record-long economic expansion is likely to continue. We think the “recession is near” theme that seemed to gather momentum over the summer will start to fade, giving way to a narrative of better global growth as we move into the first quarter of 2020. To quote our most recent Quarterly Market Insights publication, “the economic backdrop is likely to stabilize in early 2020. Although we do not forecast a dramatic reacceleration in growth, stock prices move based on expectations. Currently, economic expectations are low, so a “less bad” global economy might be good enough.”
With investor sentiment and positioning still nowhere near optimistic, a clear stabilization of global economic growth could serve as an additional upward catalyst for the market. Although we should not expect a completely smooth ride given the risks still emanating from Washington D.C., we believe stocks can modestly rise as we approach year-end.
Ten Years into the Expansion, the Economy is Still Adding Jobs. October non-farm payrolls showed an addition of 128,000 jobs, ahead of consensus estimates of 89,500. The prior two months were also revised up by 95,000. The report took many investors by surprise. Most assumed that employment growth was slowing much more dramatically than these numbers would indicate, with a 3-month moving average for job gains still a solid 176,000. Especially given the General Motors strike which likely subtracted about 40,000 jobs and some of the weaker manufacturing data reported over the past few months, this employment report could be a “game-changer.” We believe the health of the labor market underscores the idea that, although the economy may be slowing relative to 2018, the pace of the deceleration is orderly and nowhere near as rapid as some had assumed only a few short months ago. A stronger economy could also mean that earnings expectations for 2020 (currently at 9.8% growth) may not have to come down as dramatically as some thought, putting less pressure on rising multiples.
The better-than-expected employment report is consistent with the Federal Reserve’s (Fed) current policy stance. Since their last interest rate increase in December 2018, the Fed has provided additional monetary accommodation with three rate cuts while recently signaling that the economy may not warrant additional rate reductions. For the stock market, that is a good thing. From here, we should want less cuts, not more.
Manufacturing – Down Not Out. Last week we received the October 2019 reading for the ISM’s manufacturing PMI. At 48.3, the report lagged the estimate of 49.0 but was higher than last month’s reading of 47.8. Over the past few weeks, we have discussed our view that the global manufacturing cycle would bottom in the first quarter of 2020. We think that the October manufacturing PMI report provides further evidence of that thesis slowly materializing. Although 48.3 still indicates contraction (anything above 50 signals expansion), the important New Orders component of the report jumped from 47.3 to 49.1. Our view is that we are in the early stages of the bottoming process.
Changes in interest rates impact the economy with a lag and we are still in the later stages of digesting the move higher in rates we experienced in 2018. Since then, rates have moved meaningfully lower. Lower rates should be supportive of the economy in the first quarter of 2020.
ISM Manufacturing PMI (right axis) versus the 2-yr Change in the 10-yr Treasury Yield (lagged 18 months; inverted on left axis)
Source: BMT; FactSet, Inc.
It is also noteworthy that the Markit Manufacturing PMI was released last week at 51.3, which is still firmly in expansion territory. The difference is likely driven by the ISM’s bias toward larger companies that more readily reflect growth issues outside the U.S. Market data has a higher correlation with actual U.S. output and probably better reflects the domestic U.S. economy. An upturn in manufacturing usually coincides with more “risk-on” or pro-cyclical market leadership.
New Highs – Under the Hood. We have also discussed market leadership in very basic terms – Defense or Offense? Because we believe a more pronounced and obvious upturn in leading economic indicators like PMI will not occur until early 2020, we also believe a sustainable rotation into more pro-cyclical areas of the market (whether that be Value or traditionally cyclical sectors like Materials, Financials, or Energy) may take time. A pro-cyclical rotation may be exactly what this market needs to push higher in 2020. Even though the broad S&P 500 closed at a record high of 3,066 last week, the vast majority of sectors cannot boast the same accomplishment. Note that the most cyclical sectors have been below their respective record-highs the longest.
Source: BMT; FactSet, Inc.
As we pointed out in last week’s publication, certain cyclical sectors are already showing signs of life. Industrials, for example, on an equally weighted basis (a better representation of the average industrial stock) have already broken out to new highs.
Source: Strategas Research Partners
In our view, it is possible that we could still see some soft economic data heading into year-end, and earnings estimates for 2020 will likely continue to come down some. Therefore, if being tactical, we suggest waiting for any aggressive pro-cyclical positioning until the positive turn in manufacturing data is further confirmed. Once the cyclical rebound occurs, it will likely persist for some time, so there is not a significant risk in being a bit late.