Economic Update 10-22-2018

• Economic data for the week was highlighted by mixed but still-strong results from manufacturing, continued growth-oriented results from a key index of leading economic indicators, weaker retail sales affected by storm activity, and poor housing market results.
• Developed equity markets were flattish in the U.S. due to a variety of positive and negative cross-currents, while emerging markets lost ground.  Bonds also declined as interest rates rose.  Commodities generally declined along with the price of crude oil.

U.S. stocks were essentially flat for the week, with large caps eking out a small gain, while small caps lost some ground.  From a sector standpoint, defensive groups led the way, as staples and utilities experienced gains of several percent, led by a strong earnings report by Procter & Gamble, while energy and consumer discretionary each fell back by about -2%.

A degree of market volatility continued with the unending concern over impact of the U.S.-China trade conflict, in addition to the new backlash surrounding the role of Saudi Arabia in the death of a prominent journalist in Turkey.  Such news events generally don’t affect stock prices, but the unique and sometimes-strained U.S.-Saudi relationship is again being tested, with ramifications for regional power balance with Iran, defense contracts and energy policy (and prices).

The sad news from early in the week was the announced Chapter 11 bankruptcy of Sears.  Of course, this didn’t really come as a surprise to anyone, as the firm has been in financial trouble following a drawn-out turnaround attempt by investor Eddie Lampert.  While the retail sector overall has been facing headwinds from changing consumer tastes and the interest medium (including the rise of Amazon), Sears appeared to have an especially difficult time adapting to this new world, saddled with a lack of direction and too many stores.  (Ironically, the value of the firm became based on its immense real estate holdings than its retail prowess of old.)  In many ways, the other irony is that Sears was the ‘original’ Amazon, over a century ago, by mass merchandising items in a mail order catalog (including items as elaborate as kits to build an entire home) which challenged the supremacy of the smaller local dry goods stores of the time of the time.  The ultimate fate remains to be determined—whether it’s a restructuring (which includes debt write-downs supervised by the courts) or a total shutdown.

Mid-term elections are also around the corner, the prelude to which has historically added to market volatility.  Interestingly, periods following the conclusion of the elections has been positive for equities in the months afterward.  In fact, the S&P has not experienced a negative return in the 12 months following a mid-term election since 1946.

Earnings results for Q3 are also continuing to roll in.  Per FactSet, firms have seen a more negative impact from a strong dollar than they have from the tariff talk—at least thus far.  On the other side, firms are expected to report the second highest net profit margin in the last ten years (at just under 12%), largely driven by the recent corporate tax cuts, and over the trailing 5-year average that sits just over 10%.  Earnings are expected to come in showing 19% growth year-over-year, with about a third of the recent quarter’s results originating from tax cut impacts.  Profit margins are also expected to come in at just under 12%, based on operating earnings, which is the highest in decades.

Foreign stocks were slightly down in developed markets, with the headwind of a stronger dollar, continued uncertainty about the Italian budget situation and weaker corporate earnings results in that region compared to those in the U.S.  The chances of a Brexit deadline being reached without a deal with the EU is also looking increasingly possible, which has kept uncertainty high and pressure downward on the British pound.  Emerging markets suffered losses of over a percent as trade concerns and effects on economic growth led to negative sentiment.  Chinese growth has eroded to 6.5% for Q3, the weakest pace in nine years, in keeping with a stock market reaching a four-year low—all resulting in recent announcements of further government stimulus and continued negative sentiment towards emerging markets in general.  Brazil, on the other hand, gained sharply on the week, as the populist pro-business presidential candidate looked to increase his lead in the polls a week before the runoff election.

U.S. bond prices pulled back in keeping with interest rates ticking upward.  Treasuries outperformed corporate credit slightly, as spreads widened, with senior loans ending the week with positive returns.  Foreign bonds similarly pulled back in developed market regions, hurt by the dollar’s move higher, while emerging market local debt recovered by nearly a percent to offset negative momentum of the past several months.  Italy continues to be a key point of uncertainty in European fixed income, although Moody’s affirmed their investment-grade status to end the weekend, which kept a damper on yields.

Real estate results were mixed to higher for the week, despite higher rates.  Despite some concern over the retail sector being affected by the Sears news, most of the larger retail REITs, which are focused on higher quality, multi-use regional malls, haven’t or don’t appear to be overly affected by the news.

Commodities were generally weaker, along with the headwind of a stronger dollar, with precious metals ending the week as the only group in the positive.  Energy lost the most ground, offset by a sharp gain in natural gas and -3% decline in crude oil to end at just over $69/barrel.  Interestingly, Saudi Arabia has announced an increase in output to ease recent high prices, no doubt somewhat politically motivated by the recent Turkish embassy scandal they’ve been involved in.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.                                                                              

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.