For the week ending November 22, 2019
This publication is provided by BMT Wealth Management.
S&P 500 Marks Time After Recent Advance; Trade & U.S. Economy Remain the Focus
The S&P 500 Index was unable to add to its streak of six consecutive weekly gains, as it finished with a modest loss of -0.29% for the five-day period just ended. Equities arguably deserved a breather after the advance registered during the recent run up. With the modest setback, the S&P 500 has returned +26.3% year-to-date.
Over the course of 2019, the overriding issues for financial markets have been trade negotiations with China and the Federal Reserve (Fed) lowering interest rates. These two variables seem inextricably linked, as the Fed was motivated to cut interest rates, at least in part, to counteract the economic damage created by the trade tensions.
Looking ahead, the Fed has now signaled that additional rate cuts are less likely. Investors have interpreted this shift in messaging as a positive – the economy does not need a further reduction of interest rates. With less uncertainty around monetary policy, markets are keenly focused on any developments in the trade negotiations, as well as looking for evidence that the Fed’s actions thus far are helping to revive flagging economic growth.
Although the path has clearly not been without bumps, negotiations on a Phase One China trade deal appear to be moving forward. Most recently, China said it will raise penalties for intellectual property rights violations, which has been a key sticking point for the United States. As to the health of the economy, certain metrics appear to be signaling improvement.
A Bottom in Manufacturing?
We previously noted that the ISM Manufacturing Index has dipped below 50, signaling contraction in that sector of economy. Even as manufacturing has become a smaller part of our economy, this data series tends to be a good leading indicator of broad economic health. While the most recent reading turned modestly higher, it remained below 50 for the third consecutive month, with the next reading on this Index due on December 2. However, as the chart below displays, a similar U.S. manufacturing Index never breached 50, and it too is heading higher.
Two Appraisals of the State of U.S. Manufacturing (Trailing three years)
Source: Bloomberg, L.P.
Why the difference? The Markit Index asks companies to answer questions only as it relates to their domestic factories, whereas the ISM Index does not so stipulate. Consequently, the Markit Index is likely a better reflection of the U.S. economy.
The current consensus estimates call for the ISM Index to regain the 50 level early next month, which would validate the Markit Index. Looking more globally, it is also noteworthy that the percentage of countries with a rising Purchasing Manager Index (PMI) was up to 35% in the third quarter, versus just 17% during the second quarter. While far from a certainty, these readings support the case that manufacturing, not only in the U.S., but more globally, may be bottoming. If true, this would argue that there is more life left in this long running economic expansion and that earnings for many economically sensitive companies will likely trend higher over the coming months.
Canary in a Coal Mine is Doing Just Fine
Recession fears have increased over the course of the year, and one area of the financial markets that has historically proved worth watching for signals of economic deterioration is high yield credit spreads. Credit is the life blood of the U.S. economy, and looking at the rates lenders demand from sub-par borrowers provides a good signal as to how they view the future. The chart below details these spreads for what are arguably the most economically sensitive sectors of the market.
Source: Strategas Research Partners
While spreads have widened out meaningfully for energy borrowers, that stress seems more likely to be a function of the impact of lower commodity prices due to the shale revolution, or sector-specific issues, and less an indication of any widespread economic problems. In previous instances of economic concern, these sectors have tended to move in concert, and that is clearly not evident at this time.
The short take would be that the high yield market does not see a recession as imminent, and we certainly concur. For that matter, stock investors seem to be firmly in the “better news is coming” camp. As the table below displays, the sectors that we would dub the “safety trade” (bond substitutes, and less economically sensitive sectors) have substantially underperformed the more economically sensitive sectors since the beginning of the third quarter. This portfolio positioning would clearly be at odds with a coming recession, and evidences that equity investors feel the economy is poised to rebound.
Source: BMT; Bloomberg, L.P.
Investors Surveyed, but Vote with Their Portfolios
Earlier this month we wrote on the AAII Sentiment Survey, that simply asks investors if they are bullish, bearish, or neutral on stocks for the coming six months. This tends to be a good contra indicator. So, if investors are more bullish (bearish) on stocks that would be viewed as a negative (positive) sign. In other words, investors tend to be the most optimistic at exactly the wrong time. After weeks of pessimism (bears outnumbering bulls), we began to see some optimism return to survey-based measures of investor sentiment. While investor pessimism may be less of a market asset than it was a few weeks ago, we are not seeing the type of overly optimistic conditions that tend to precede a major market decline.
Source: Strategas Research Partners
Another way of evaluating investor optimism is to view what is actually occurring in portfolios. On this front, the chart above shows the total balances within money market funds since 1990. At present, the $3.57 trillion is starting to rival the amount which fled to this safe asset during the Great Recession. Admittedly, on a percentage of assets basis it is far lower given the run up in stock prices, however, it would still be hard to interpret this chart as one where investors are exceedingly optimistic at present. Then too, in the most recent AAII Survey, even the modest level of bullishness noted two weeks ago, has begun to recede. Neither measure points to any degree of widespread investor euphoria as it relates to stocks, historically a good thing for equity investors.
Best wishes to all for a very Happy Thanksgiving.