The U.S. economy split sharply in 2019—manufacturing activity lagged services, corporate profits lagged stock performance—while investor sentiment surged. How long will these divergences continue in 2020?
The global economy is showing signs of stabilization, but global stocks priced in much of that improvement last year. This could mean weaker global stock market performance in 2020 than in 2019, despite a better economy.
Treasury bond yields are likely to move modestly higher during the first half of the year. However, market inflation expectations are low, implying the market may be unprepared for an unexpected rise in prices.
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Some trends in the U.S. economy hit a fork in the road last year—manufacturing activity lagged services, corporate profits lagged stock performance—while investor sentiment surged. Although some market headwinds have faded as global growth has improved and trade tensions have de-escalated, some still remain—including tariffs and dampened corporate animal spirits. The question is how long these divergences will continue, and how they’ll be resolved.
U.S. stocks and economy
Several diverging trends developed in 2019 as the U.S. economy bore the pressure of a slowing global economy, weak earnings growth, and the U.S.-China trade war.
Notably, manufacturing activity slipped into contraction territory, while the services side of the economy largely steered clear of manufacturing’s malaise.
In December 2019, the Institute for Supply Management (ISM) Manufacturing Index hit its lowest level since 2009, sliding below the 50 level that separates expansion from contraction. The Non-Manufacturing Index has held above 50 and has ticked upward recently.
Manufacturing activity has slipped into contraction, while services has stabilized
Source: Charles Schwab, Bloomberg, as of 12/31/2019.
There also has been a divergence between manufacturing activity and U.S. stock prices, which have continued their climb into record territory. You can see from the chart below that the S&P 500® index and the ISM Manufacturing Index both have diverged sharply from their averages, but in opposite directions, and that spread is now at its widest point since the current expansion began in 2009. (For more on our tactical bias of large-cap stocks over small-caps, see our latest in Best of What’s Around: Sticking with Large Caps)
Stock performance and manufacturing activity have diverged sharply
Source: Charles Schwab, Bloomberg, as of 12/31/2019. A Z-score measures a value's relationship to the mean (average) of a group of values, measured in terms of standard deviations from the mean.
Meanwhile, corporate profits and U.S. stocks also show a historically wide spread. As the S&P 500 has notched new record highs, after-tax corporate profits have flattened out. History suggests that something has to give at some point—either profits must catch up to the market, or stock prices may have to correct down.
U.S. stock prices have risen much faster than corporate profits
Source: Charles Schwab, Bloomberg, Bureau of Economic Analysis. S&P 500 as of 12/31/2019. *Profits as of 9/30/2019 and with inventory valuation and capital consumption adjustments. Past performance is no guarantee of future results.
Which will give way first? S&P 500 year-over-year earnings per share (EPS) growth turned negative in the third quarter of 2019 and analysts believe EPS growth was negative again in the fourth quarter.1 Earnings growth forecasts are higher for 2020—but not all macroeconomic headwinds have faded, including tariffs and dampened corporate animal spirits. On the other hand, low interest rates and low inflation continue to support higher-than-average equity valuations.
Meanwhile, investor sentiment has risen to what can only be described as extreme optimism. One example is SentimenTrader’s “smart money/dumb money” Confidence Indexes, which reached a historically wide spread in December—with “dumb money” (retail investors and trend-followers) at an extremely optimistic level compared with “smart money” (institutional accounts). This is considered a contrarian indicator, because at extremes “dumb money” investors have tended to be wrong, while “smart money” investors have often correctly sniffed out short-term market tops/bottoms.
The names are not meant to imply that retail investors are “dumb”—in fact, they are by definition correct during the bulk of a trend—but when retail investors move overwhelmingly into a bullish or bearish position, the trend historically has been vulnerable to a reversal.
“Dumb money” is showing extreme optimism
Source: Charles Schwab, SentimenTrader, as of 1/14/2020. Confidence Indexes are presented on a scale of 0% to 100%. When the Smart Money Confidence Index is at 100%, it means that those most correct on market direction are 100% confident of a rising market. When it is at 0%, it means good market timers are 0% confident in a rally. The Dumb Money Confidence Index works in the opposite manner.
Investor sentiment at extremes doesn’t necessarily signal imminent market weakness, but it does suggest that stocks may be more vulnerable than usual. Although monetary policy and financial conditions remain supportive and global growth is stabilizing (as discussed below), risks include weaker-than-expected earnings and ongoing geopolitical uncertainty.
Global stocks and economy
The global economy is showing signs of stabilization after slowing in 2019. Last week, the World Bank published its latest global growth forecast of 2.5% for 2020, up slightly from 2.4% in 2019—but failing to recover back to the 3%-to-3.2% pace of growth seen in 2017 and 2018.
We can see this stabilization in the Organization for Economic Cooperation and Development (OECD) Total Composite Leading Indicator, which ticked up for the first time in two years after narrowly avoiding a drop below 99, a level that has marked the threshold for global recessions during the past 50 years.
Leading economic indicator ticked up just above the threshold for global recession
Note: Although 100 officially marks the dividing line between an accelerating or slowing global economy, 99 has historically marked the threshold for global recessions over the past 50 years.
Source: Charles Schwab, Organization for Economic Cooperation and Development (OECD) data as of 1/8/2020.
Manufacturing has been the weakest sector of the global economy. Yet even manufacturing has shown signs of improvement, with a widely watched global manufacturing purchasing managers’ (PMI) index lifting to just above 50, which marks the dividing line between growth and contraction.
Manufacturing PMI recently stabilized above contractionary territory
Note: 50 marks dividing line between expansion and contraction in the global manufacturing sector.
Source: Charles Schwab, Bloomberg data as of 1/8/2020.
Geographically, the economic downturn had been deepest in Europe, disappointing economists’ expectations for much of the past two years. The Citi Economic Surprise Index for Europe has now risen back above zero, reflecting economic data exceeding economists’ expectations, as you can see in the chart below.
Europe’s economic data now surprising to the upside
Zero marks the threshold between economic data surprising on the upside or downside relative to the Bloomberg-tracked economists’ median forecast.
Source: Charles Schwab, Bloomberg data as of 1/8/2020.
More important of all for investors, earnings per share estimates are starting to rise, which may lend support to the stock market. The earnings growth rate for the global companies in the MSCI World Index have started to rebound, as shown in the chart below.
Earnings per share has trended higher
Note: Chart includes consensus analysts’ estimates for Q4 2019.
Source: Charles Schwab, FactSet data as of 1/8/2020.
While nothing like a V-shaped recovery, the widespread improvement is good news for global stock markets after last year’s strong gains priced in an end to the weakness in the economy and earnings.
However, after last year’s slowdown, even economic stability isn’t assured. The global economy remains vulnerable to threats due to several factors, including:
- There are high levels of unsold inventories, which suggest the rebound in manufacturing may be tepid without stronger end demand.
- Business investment remains weak, despite low interest rates.
- Central bankers are either on hold or have reached the lower limit on interest rates.
- Geopolitical risks have reemerged.
There are plenty of surprises that could present risks to the vulnerable economy (see our recent article on the Top Ten Global Risks for Investors in 2020).
Overall, the data is pointing to a better trajectory for the global economy than in recent quarters. But stocks had priced in much of that improvement last year as central banks provided stimulus. That could mean weaker global stock market performance in 2020 than in 2019, despite a better economy.
The bond markets have gotten off to a slow start in 2020. Ten-year Treasury yields have been in a tight band of about 1.8% to 1.9% since late last year, while short-term interest rates are anchored near 1.5%. With the Federal Reserve indicating its policy is on hold for the foreseeable future and the economy growing at a steady pace near 2%, there hasn’t been much reason for rates to move. Yet markets rarely stay in equilibrium for very long. Which way will they go from here?
We believe there is a greater likelihood that bond yields will move higher than lower in the first half of the year. Bond yields have been edging up since the lows of last summer, reflecting signs of improvement in the global economy amid easing trade tensions. Those trends appear likely to continue, based on OECD leading indicators.
Leading indicators point to improving global growth
Note: The OECD’s work is based on continued monitoring of events in member countries as well as outside OECD area, and includes regular projections of short and medium-term economic developments. Shaded areas indicate time periods where CLIs were below the long-term average of 100.
Source: OECD, as of November 2019.
Notably, bond yields are moving higher in most major developed markets—not just the U.S.—as the outlook for growth brightens.
German and Japanese bond yields appear headed into positive territory
Source: Bloomberg, using daily data as of 1/14/2020. Generic Germany 10-Year Government Bond Yield (GTDEM10Y Govt) and Generic Japan 10-year Government Bond Yield (GTJPY10Y Govt).
Any sustained rise in bond yields will need to get a boost from higher inflation and inflation expectations. While the Fed has been fretting that inflation is too low, it is focused on the lowest reading—personal consumption expenditures excluding food and energy (core PCE)—which is rising at a 1.6% pace, below its 2% target rate. However, a look at various other inflation readings, some compiled by regional Federal Reserve banks, shows that inflation is above 2%. In fact, the PCE readings are the only ones below 2%.
Many measures of inflation are above 2%
Source: Federal Reserve Bank of St. Louis, Bloomberg. PCE Deflator = U.S. Personal Consumption Expenditure Deflator; Core PCE = U.S. Personal Consumption Expenditure Core Price Index; Overall CPI = Consumer Price Index for All Urban Consumers: All Items; Core CPI = Consumer Price Index for All Urban Consumers: All Items Less Food and Energy; FRBC Trimmed-Mean CPI = 16% Trimmed-Mean Consumer Price Index % change at annual rate; FRBA Sticky Price CPI Core = Sticky Price Consumer Price Index, Less Food and Energy; FRBA Sticky Price CPI = Sticky Price Consumer Price Index; FRBC Median CPI = Median Consumer Price Index % change at annual rate. Monthly data as of 12/31/2019.
However, inflation expectations also remain muted, implying that the market may be complacent about the potential for an unexpected rise in prices. Market-implied readings of inflation expectations, such as the 5-year TIPS/Treasury breakeven rate and the 5-year/5-year forward inflation expectation rate, suggest the market is not priced for an inflation surprise.
Treasury market pricing implies inflation will average below 2% over the next five years
Notes: The 5-year 5-year Forward Inflation Expectation Rate measures average expected inflation over the five-year period that begins five years from the date the data are reported.
Source: Bloomberg, USGG5Y5Y Index. Daily data as of 1/14/2020.
Investors can prepare for potentially higher bond yields later this year by keeping the duration in their portfolios slightly lower than average, and/or adding a small allocation to Treasury Inflation Protected Securities (TIPS). We don’t anticipate a big rise in yields—perhaps only to the 2.25% to 2.5% level in 10-year Treasuries—but given the markets’ apparent complacency about inflation, the risk of an upside surprise may be greater than that of a downside surprise.
¹ Based on I/B/E/S data from Refinitiv
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