Market Musings | November 2018

Stocks might climb a wall of worry, but that wall has gotten a lot higher lately and stocks have been taking it on the chin. Since the S&P 500 hit an all-time high in early October, the list of concerns seemed to grow exponentially. As of this writing, we know the outcome of most of the midterm elections, but in the runup to them, uncertainty over which party would end up controlling the government cast a dark cloud over the market as October progressed. Midterms may be out of the way, but the ongoing trade rift with China remains problematic for markets. Tariffs are set to go from 10% to 25% in January, and rumors swirl almost daily about the possibility of still more tariffs against China, even including tariffs on ALL Chinese imports. Also, in early October comments by Federal Reserve Chief Jerome Powell in an interview were taken as hawkish and seen as a portraying an intransigence, i.e. no longer data driven, regarding the forward path of interest rate policy. This episode cast the Federal Reserve as a villain in its pursuit to normalize policy.

There are more worry bricks to add to the wall. Headlines from Italy that it will not comply with EU fiscal rules when setting its budget sent Italian stocks reeling and raised concerns over contagion similar to those surrounding Greece and Turkey in recent years. Uncertainty over “BREXIT,” Great Britain’s plan to exit the European Union, reared its head as the UK prime minister struggled to finalize her country’s separation from the EU. Of course, on any given day the potential exists for negative headlines over political investigations, failed trade negotiations, and election meddling, to name a few.

Stocks hit the skids despite another strong quarter for S&P 500 earnings. Earnings growth for the S&P 500 was about 25% in Q3. With 90% of companies having reported quarterly results, this would mark the best earnings growth since the third quarter of 2010. About 75% of the companies reported positive earnings surprises, and about 60% reported positive sales surprises. Earnings in the second quarter were similarly strong, and stocks reacted positively, vaulting to all-time highs, as mentioned. There were, however, cracks in the earnings foundation this time around. Despite the overall strong showing, some notable companies, such as PPG Industries and 3M, reported results that disappointed Wall Street, citing issues such as tariffs and cost inflation as reasons for the shortfalls.

With some of the mounting worries now manifesting themselves in the earnings reports of large companies, investors became concerned about the sustainability of earnings growth and the outlook for 2019. After all, if trade tensions persist, tariffs are ratcheted up, and the Fed continues to tighten in the face of these pressures, we may have seen the best this business cycle has to offer for corporate earnings. We believed the rate of earnings growth would slow next year, but mounting uncertainty caused some to opine that perhaps earnings would not grow at all next year given these issues.

With the holiday season right around the corner, we will offer some reasons for hope. First, both China and the U.S. have a lot to lose if the trade war gets worse. China’s economy is slowing and is in more of a fragile state than it has been in a while; and the U.S. stock market, to which President Trump has made clear reflects the success of his economic agenda, does not like the trade tensions. When the leaders of the two countries meet at the end of the month, there are incentives to make progress on trade. Second, we think the market overreacted to the Fed chief’s comments, and that even a slightly more accommodative tone would go a long way to assuaging fears that the Fed is ignoring real-time changes in economic data when affecting policy. We do not think they are oblivious to, for example, the plunge in oil prices or the still-benign readings on inflation from the CPI. Finally, consensus estimates are still calling for S&P 500 earnings to rise 7%–8% next year. While slower than earnings growth this year, which was juiced by the tax cuts, high-single-digit growth is still robust when viewed in a broader context.

- Jack Kasprzak, CIO