Insights and Commentary

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Market and economic update


Current economic events

Week of November 4, 2019

A veritable mountain of generally weaker economic data and volatility in policy events were mostly set aside last week as better-than-expected third quarter earnings helped drive the S&P 500 to a new all-time high. The Federal Reserve (Fed) delivered on market expectations of a 0.25 percent cut to interest rates, the third such cut this year. However, it played down chances of coming through with a fourth cut in December. It appears the market is accepting the likelihood that more support from the Fed may not materialize. Washington drama also failed to upset markets. The House of Representatives passed a resolution outlining the rules for a presidential impeachment inquiry; a prolonged impeachment proceeding may catch headlines, but we believe chances of outsized market impact are limited.

Trade news continues to be a market-driving issue. Although Chinese officials on Thursday expressed doubt about the chances of making a long-term deal with President Trump, a focus on the general de-escalation of tensions has helped drive markets to records. Both sides still expect a “phase one” trade deal in the near term. Also, the United Kingdom Parliament passed Prime Minister Johnson’s proposal for fresh elections in December, a vote that likely reduces the chances of a “hard” Brexit in which the U.K. leaves the European Union without its former trade ties.

Third quarter U.S. gross domestic product (GDP) data confirmed our view that growth in the economy has continued to taper. GDP increased 2 percent year-over-year in the third quarter, the slowest rate since the fourth quarter of 2016. The report indicated business investment stagnated over the past year and strong consumer spending supported the economy. The Bureau of Labor Statistics jobs report and ADP employment report depicted private companies continuing to scale back job growth, showing employment growth falling to its slowest rate since September 2017 and March 2011, respectively. The jobs report also showed the unemployment rate ticking up off multi-decade lows and wage growth holding up near cycle highs. Business sentiment measures from the Institute of Supply Management, Markit and the ISM-Chicago Business Barometer indicated, on average, continued weakness across manufacturing. Consumer confidence, as represented by the Conference Board survey, slipped from its strongest levels, perhaps an indication the labor market may be past its peak strength. Lastly, the core personal consumption expenditure deflator, the Fed’s preferred measure of inflation, ticked down and remains below the 2 percent target. We see U.S. economic health as slightly below long-term averages, with our proprietary “Health Check” at its weakest point in three-and-a-half years and trending downward.

Third quarter year-over-year GDP growth in the eurozone slipped to its lowest level since the fourth quarter of 2013; sluggishness in Germany and Italy, among others, pulled down aggregate growth. Headline consumer price inflation continued to soften, slowing to nearly a three-year low in October, though core inflation ticked higher. October European Commission sentiment indicators disappointed, with both industrial and service sector confidence falling and the economic confidence indicator, which is highly correlated to GDP growth, dropping to its lowest level since January 2015. Although the German unemployment rate remained steady, employment grew at its slowest rate since February 2015. This is an ominous development for third quarter GDP, which is expected to show Germany flirting with recession. In Japan, retail sales rocketed higher in September with the best month-over-month increase in history. However, we believe the boost was almost entirely the result of a massive government stimulus package for consumers designed to cushion the impact of the consumption tax hike implemented on October 1. We saw a similar, though not quite as large, rise in March 2014, the month before the nation’s previous tax hike, with sales cratering the next month as the higher taxes dampened consumer spending. The October manufacturing Purchasing Managers’ Index (PMI) was revised downward to its lowest level in three-and-a-half years, with respondents signaling increased downside risks to Japanese growth. Even with the blowout sales number, Japan has now slipped below its long-term average in our Health Check and is trending down at an increasing rate. Our overall foreign developed Health Check has fallen to its lowest point since October 2013 and continues to trend down.

Within emerging markets, divergences popped up in the Chinese business sector. Official PMIs showed continued slowing, with manufacturing PMI hitting a seven-month low and non-manufacturing PMI a tick off its worst reading since 2009. However, Markit/Caixin showed that manufacturing PMI, a survey focused on smaller companies, surged to its best level since February 2017. Other emerging market PMIs were more mixed, with Mexico, Russia and South Korea improving (though Russia and South Korea are still in contractionary territory) but Brazil and India falling. Industrial production growth improved in Brazil and South Korea in September, with Brazil’s reading rising out of contraction. South Korean trade data was less encouraging; contractions increased in both exports and imports, now at the fastest rates since mid-2016. Still, some of the worst-performing emerging economies we track, including Turkey, South Korea, Russia and Taiwan, have improved off their weakest levels in our Health Check. This improvement, as well as a modest uptick in China, has caused our aggregate emerging market Health Check to rise to a seven-month high.

Equity markets

The S&P 500 ended last Friday at an all-time high of 3,066, favorably impacted by better-than-expected earnings trends, continued accommodative monetary policy and a positive employment report. Our risk-on (aggressive) bias remains intact, bolstered by restrained inflation, low interest rates, moderate earnings growth and uninspiring alternatives.

The third quarter earnings season is approaching an end, with overall results modestly exceeding expectations, according to Bloomberg. Roughly 70 percent of S&P 500 companies have released results as of November 1, with another 17 percent slated to release results this week. Here’s what we’ve seen so far:

  • Leading into earnings season, consensus expectations were for sales to increase 2.8 percent and earnings to decline 4.3 percent, according to FactSet Research Systems, with both numbers negatively influenced by sluggish global growth and trade uncertainty. Actual results are exceeding expectations. As of Friday’s close, sales are trending up 3 percent while earnings are declining 1 percent.
  • Utilities, Healthcare, Real Estate and Communication Services are the sectors posting the highest year-over-year earnings growth, advancing between 7.2 and 8.6 percent over year-ago levels. Energy, Materials and Information Technology are the three sectors posting the greatest year-over-year losses, declining 34.5, 25.3 and 5.7 percent, respectively.
  • Soft results from companies within the Energy and Materials sectors are understandable, reflective of soft global growth. Importantly, Information Technology remains a standout, particularly given that the sector represents roughly 22 percent of the S&P 500 market capitalization. The negative third quarter results over year-ago levels are largely driven by lackluster performance from the hardware and semiconductor industry groups. Conversely, earnings for the software industry group, representing roughly half of the Information Technology sector, is up 9 percent year-over-year. The strong performance of software companies has been among drivers of overall higher equity prices.

The Goldilocks-like “not too hot, not too cold” pace of U.S. economic growth, evidenced by the Fed’s continued accommodative monetary policy and stable employment environment, provide valuation support and the basis for stocks to inch higher. The S&P 500 ended Friday trading at roughly 20 times trailing 12-month earnings estimates, above the 40-year average of approximately 17.5 times.

Our year-end single-point price target for the S&P 500 is 3,135, 2.2 percent above Friday close, based on a multiple of 19 times estimated earnings of $165 per share. Our preliminary 2020 year-end price target is 3,325, 8.4 percent above current levels, based on a multiple of 19 times estimated earnings of $175 per share.

Fixed income markets

The Fed’s 0.25 percent cut in the target funds rate last week pushed short-term Treasury yields lower. The Treasury curve continued to steepen, with longer-term yields falling only slightly. Fed Chairman Jerome Powell implied a preference to hold rates steady for now but signaled willingness to adjust rates if needed. Market expectations for future cuts are in closer alignment with this message, removing a potential catalyst for volatility in the near term. The market is pricing in only one more cut in 2020 instead of the multiple cuts priced in a month ago. Powell also stated rate hikes are unlikely until inflation increases for an extended period. We expect a pause in the funds rate, considering the bar is high for both rate cuts and rate hikes. Other foreign central banks are also slowing the pace of rate cuts, potentially reducing downward pressure on yields. We suggest that investors hold portfolios with duration just below the benchmark in portfolios of U.S. Treasuries and high-quality corporate bonds, given limited incremental yield for longer-term bonds. Slightly longer duration exposure is warranted in municipal bond portfolios due to steeper curves in that portion of the market (higher yields at longer maturities).

U.S. investment-grade corporate bond spreads were essentially unchanged last week, but high yield spreads widened. The spreads in both categories remain below long-term medians. We view valuations as slightly expensive but reasonable, because monetary policy is accommodative, defaults are low and the ability of companies to service their debts remains adequate. We also see value in mortgage-backed securities not backed by the government, which can replace some exposure to corporate credit risk and provide attractive yield. Bond portfolios should be primarily comprised of high-quality debt to provide diversification against higher return, higher risk holdings.

Real assets

Defensive sectors underperformed last week as the recent shift to a “risk on” market environment continued. For the year, the Infrastructure and Utilities sectors have underperformed the S&P 500 while Real Estate has outperformed by 4 percent. Infrastructure was the best performer last week, finishing the week with 0.25 percent of underperformance versus the broader market. Real Estate and Utilities both underperformed the S&P by 1.5 percent. With valuations in defensive stocks stretched and fundamentals slowing, these sectors will have difficulties in an extended “risk on” market with higher interest rates. A price correction could be potentially severe in that environment.

Crude oil prices, as represented by West Texas Intermediate (WTI), fell 0.8 percent last week. For the year, WTI is up almost 24 percent. Domestic fundamentals were neutral for prices, with an increase in domestic crude inventories and production levels at an all-time high. However, these factors were offset by declines in the inventory of refined products and another decline in rig counts. A bigger development appears to be a bottoming of energy stocks. After serious underperformance of the sector over the past few years, energy stocks have rebounded in the past month. While it is still early, a generally aggressive market environment, coupled with a shift to a more reflationary economy, could be very promising for the energy complex.

The gold market was up 1 percent last week and is now up 18 percent for the year. Gold prices have eased recently as 10-year U.S Treasury rates moved slightly higher. However, central banks re-engaging in balance sheet expansion (quantitative easing) policies have been the catalyst for higher gold prices. With more than $15 trillion in negative-yielding fixed income securities across the globe, precious metals currently have a potential advantage to some of the global sovereign bond market.

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This information represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated or associated with any organizations mentioned.

Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Diversification and asset allocation do not guarantee returns or protect against losses.

Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for direct investment. The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer's ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. Investments in mortgage-backed securities include additional risks that investors should be aware of, such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).

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