In this June edition of Charting the Market, we’ll look at what's going on from a global economy perspective, including how trade tensions have impacted growth projections and sector performance. We’ll also tackle the question of whether the current slowdown and movement in the yield curve means a recession is right around the corner—or not.
Chart #1: Global economic sentiment negative as manufacturing down
Global economic sentiment rolled over in 2018 and remains negative in 2019. Eurozone economic sentiment has been recovering since April on the heels of some improvement in manufacturing activities and better-than-expected Q1 GDP. Most countries/regions, except the US, are now in contraction territory, as trade tensions escalated. US sentiment bottomed out in May but could face more stress in the coming months, as trade flare-ups may dent business sentiment further.
While the US has been at the forefront of trade tariff discussions, Germany has notably had a sizable downturn in its manufacturing indices due to its reliance on emerging market demand for the goods it produces. What does it mean? We’ve been in a global economic slowdown for some time. And because leading economic indicators in the US have been moving lower year over year since November 2018, the US is experiencing a slowdown too.
Source: Bloomberg Finance L.P., as of 05/31/2019. Below 50 indicates contraction; above 50 indicates expansion.
My take: The economic growth music is slowing, but it hasn’t stopped. And a slowdown doesn’t mean negative market returns. Quality has historically led amid slowdowns and it’s leading again this year, outperforming the broader market by 3.2%. Still, investors will want to be judicious about where they allocate capital. Targeting quality stocks, as opposed to value or size, may be beneficial when there’s a stronger preference for sustainable cash flows.
Chart #2: US growth expectations lag behind despite upbeat sentiment
Earnings growth projections for 2019 have not changed much since February in the US and emerging markets (EM). EAFE earnings growth decreased slightly, but still outpaced the US and EM. While growth projections slightly rebounded after bottoming out in March, the rebound amounted to less than one percentage point. So growth is slowing and expectations have moved lower.
Source: FactSet, as of 05/30/2019. EPS growth estimates are based on Consensus Analyst Estimates compiled by FactSet.
My take: Projected growth for the US may be lower, but sentiment is more positive when we look at earnings upgrade-to-downgrade ratios. Because there was such a big jump from March to April in the upgrade-to-downgrade ratio, we’ll be keeping an eye on it to see if the trend continues. The 800-pound gorilla in the room is, “How will trade impact these upgrade-to-downgrade ratios? Will companies start to have lower guidance?” Analysts could start to downgrade projections based on tariffs applied to not only Chinese imports, but also other countries. We’ll be watching.
Chart #3: Global sectors embedded in supply & demand see big cuts in projected growth
Except for Utilities, sectors with less revenue exposure to foreign markets—like Health Care, Real Estates and Financials—ranked top 3 in terms of earnings revision. As trade tensions escalated, sectors embedded in global supply and demand saw the biggest cuts in growth projections for the upcoming quarter.
Negative earnings sentiment is also the result of uncertainty about how trade will impact supply chains. Will they be disrupted? Will their margins be compressed because they might have to bear the higher costs to the consumers of tariffs? Interestingly, Utility stocks have sidestepped some of this trade-related insecurity. Why? Because Utilities only get 3% of their revenue from overseas, making them somewhat immune to the fluctuations in the dollar that we've witnessed as a result of trade tensions.
Technology, a globally exposed sector, earnings sentiment is basically middle of the road. Meanwhile, price momentum has been very strong as investors seek out the high growth area in light of waning broad-based growth.
Source: FactSet, as 05/31/2019. EPS growth estimates are based on Consensus Analyst Estimates compiled by FactSet. This information should not be considered a recommendation to invest in a particular sector. It is not known whether the sectors shown will be profitable in the future.
My take: While Utilities have seen increases in their earnings estimates, there hasn't been a lot of depth to them. A little bit of negative earnings sentiment lurks beneath the surface when we look at the amount of earnings surprises they had last quarter. As earnings season kicks off, we’ll be watching to see if Utility stocks will be able to fulfill the positive sentiment we've witnessed over the last few quarters. And while technology is one of the leaders headed into the earnings season, if there is disappointment, we could see higher volatility in that sector as valuations have become extended.
Chart #4: Yield curve flattened, but is recession looming?
Any conversation about economic slowdowns naturally leads to the question of, “When will we have a recession?”
The 10-year minus 3-month yield has inverted. Technically, that’s a reliable indicator of a looming recession with a lag around 16 to 18 months. But while the economy may be slowing, it’s still doing well. Job creation is robust. Wages are growing. And we haven’t been saddled with the negative connotations that typically occur when a recession is right around the corner.
That said, the curve has flattened due to the dramatic rise in short-term rate since the Federal Reserve began raising rates in December 2015. Meanwhile, long-term rates have seen muted moves. This has flattened the curve substantially, while the consistently negative term premium indicates a pessimistic outlook for economic growth and inflation.
Source: Bloomberg Finance L.P., as of 05/31/2019. Past performance is not a guarantee of future results. The term premium is the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds.
My take: As far as recession goes, I think 2019 is off the table. 2020 is a possibility depending on how trade plays out. But then again, I doubt the current administration would push trade so far to the brink that it sends the US economy into a recession right around election time. For real-time insights, just look at the yield curve. The 10 minus 2 is still positive and having a really hard time going negative, which I think is a result of vastly negative term premiums. With such negative term premiums, there isn't much more room for that yield curve to move.
Important Risk Information
A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.
The monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be “flat,” it means the difference in yields between bonds with shorter and longer durations is relatively narrow. When the yield curve is said to be “steep,” it means the difference in yields between bonds with shorter and longer durations is relatively wide.