U.S. equities have pulled back after stalling around record highs. We believe that a pullback is healthy and could have further to go, but would never suggest an all-or-nothing strategy like “sell in May and go away”.
Trade uncertainty jumped back into the headlines with threats of additional tariffs coming alongside worsening prospects of a China/U.S. deal. Earnings season was mostly better than low expectations, but still only roughly flat in year/year growth. The economy continues to look fairly solid, although there are some cracks under the surface that raise some concerns.
It’s not just the United States that suffers from the trade war; however lower correlations among major global asset classes bolster the case for diversification.
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“If your friend jumped off a bridge, would you go ahead and do that too?”
― Moms everywhere
Follow the crowd?
In honor of Mother’s Day, we weigh the above advice against the old Wall Street adage coined by Liz Ann’s first boss/mentor Marty Zweig: “The trend is your friend.” For long-time readers of this publication, it won’t surprise you that we side with mom—keeping with your long-term plan and maintaining a diversified portfolio. We would also add another long-time Wall Street adage in there: “Bulls make money, bears make money, pigs get slaughtered.” If you have gains after this recent rally that have resulted in the equity portion of your stock portfolio moving out of your long-term strategic comfort zone, taking profits may be prudent. As seen in the past week, direction and momentum can both change quickly.
Stocks rebounded from the “near bear market” low in late December, but stalled as new records were set; before pulling back this week as trade tensions with China ratcheted up. We wouldn’t mind seeing the pullback pick up a bit of steam in the interest of bringing in both sentiment and valuations, which had gotten stretched recently. We have no special or unique insight into the trade discussions, and there is a chance that the dispute could escalate and be a bigger drag on both stocks and the economy—bolstering further the case for diversification across and within asset classes (more on the trade dispute below).
Sentiment had moved further into the extreme optimistic territory according to the Ned Davis Research Crowd Sentiment Poll, typically a contrarian indicator at extremes (see first chart below). In addition, SentimenTrader’s so-called “Smart Money” Confidence (the non-contrarian indicator) had moved to historically-low levels; while the so-called “Dumb Money” Confidence (the contrarian indicator) had moved to extreme optimism (see second chart below), although the recent pullback has dented both of those measures.
Sentiment still overly optimistic
Additionally, there may be additional selling pressure as we enter a historically weaker time of the year—promoted by the “sell in May” adage. We can’t deny that there is much truth in that saying, but we would never promote an all-or-nothing trading strategy based on the calendar. According to Bespoke Investment Group, since its inception in 1928 (through 2018), if you only owned the S&P 500 between November and April, your return would have been significantly higher than if you only owned it between May and October. You can see the various comparisons by time frame:
Past performance is no guarantee of future results.
As mentioned, investor sentiment has gotten extended, but it doesn’t appear that investors are rushing to put money into stocks, which would raise the threat of a “melt-up.” Strategas reports that eight out of 11 sector ETFs (Exchange Traded Funds) have actually seen outflows year-to-date, with the major exception being Communications Services (on which we have an “underperform” rating—see Schwab Sector Views for more.)
The first four months of the year were positive for the S&P 500; which, according to Strategas Research, has happened 15 times since 1950. Although past performance is no guarantee of future results; the good news is that in the remaining eight months of the year, the average gain was 10.0%. Importantly though, there was some interim drama, with the average drawdown during those years being -8.1%.
Where does that leave us? We believe a larger pullback would help ease both sentiment and valuation excesses. But we also believe we are late in the economic cycle and that recession risk is rising. If last year’s near-bear market was not a warning sign of a near-term recession, U.S. stocks are likely to resume their rally. However, if the yield curve were to invert again, a trade deal to fall apart and/or economic data were to continue to disappoint, a recession might begin sooner than the consensus believes; which would be a risk for stocks. For now, we remain “neutral” on U.S. equities, which means we are recommending investors remain at their long-term strategic allocation to stocks, without letting rallies get investors “over their skis.”
In some ways, we are in historically-uncharted territory. The first read on first quarter real gross domestic product (GDP) was better than expected at 3.2% (Bureau of Economic Analysis); although boosted by inventories and net trade, both of which are expected to ease in the second quarter. With decent economic growth and an extremely tight labor market, it’s notable that little inflation has been witnessed. Whether the lack of inflation is temporary or secular is yet to be seen, but for now we believe it is keeping the Federal Reserve on the sidelines with regard to interest rates.
Tight labor market
But continued low inflation
Reasons for the lack of inflation are confounding economists everywhere, including the Fed. Fed Chairman Jerome Powell, in the press conference following last week’s Federal Open Market Committee (FOMC) meeting, pointed to unspecified “transitory factors” keeping inflation below the Fed’s 2% target. We would point to the recent improvement in productivity as one encouraging reason. Higher productivity, alongside higher potential GDP, means restrained unit labor costs and in turn likely lower inflation.
Productivity may be perking up
So everything’s rosy, right? Unfortunately, we are starting to see some cracks under the surface of the economy. Initial unemployment claims is a key leading economic indicator, and they’ve been ticking up over the past few weeks; while the Institute of Supply Management’s (ISM) Manufacturing and Non-Manufacturing Indexes were both weaker than expected in April; with notable weakness in manufacturing new orders.
Claims ticking higher
And manufacturing confidence declining
And while first quarter earnings season has been better than expected for the S&P 500; with a higher-than-average 75% of companies beating estimates as of May 9 according to Refinitiv, growth is barely positive. In addition, second quarter estimates are only modestly positive as well. With valuations stretched courtesy of the rally, the next few months could be a tough slog for stocks (for more on earnings read Liz Ann’s Saved by Zero: Earnings May Eke Out a Positive Quarter article).
Fed neither tailwind nor headwind?
One factor underpinning the rally that began late last year was the complete turnaround by the Fed from a rate hike in December 2018 to a pause since January 2019. In fact, the fed funds futures market currently has priced in the next move being a rate cut. That pendulum may have swung a bit too far too fast, with the recent Fed statement and subsequent press conference emphasizing that “the Committee will be patient” in its determination of a potential next move—indicating to us it could go either way. We will continue to listen to Fed members’ reactions to incoming data and speeches for hints as to its bias looking forward.
Bad time for trade deal delay
The market’s focus shifted over the past week as stock markets around the world pivoted from a view that a deal between the United States and China was imminent to concerns about the deal falling apart. Enflaming trade tensions via Twitter during this week’s wrap up of the talks is consistent with President Trump’s negotiating style; perhaps to deflect criticism that the deal may be too weak and/or to extract a few last-minute concessions from China. Yet, there is more risk to investors for a deal falling through now than there was a few months ago. First quarter economic growth in both the United States and China exceeded expectations and may have emboldened both sides to hold out on key concessions. Also, the talks have been challenged by efforts to create enforcement mechanisms, since China wants an immediate lifting of all tariffs rather than only after a period of good faith, according to The Wall Street Journal.
While a delay is possible, accompanied by a tariff increase from 10% to 25% on $200 billion of Chinese goods, it is still possible that talks will resume and a trade agreement is ready for a signing ceremony at the G20 summit in Japan on June 28. China has already publicly agreed to many U.S. priorities for a trade deal; including prohibitions on currency manipulation, allowing broader market access by foreign companies, implementing tougher protection of intellectual property rights and seeking more balanced trade. Many of these were outlined in a major speech by President Xi in April, as reported by Reuters.
A failure or lengthy delay to a trade deal would come at a bad time for the global economy. Global manufacturing activity is in the longest slump in the more than 20-year history of the global purchasing managers’ index (PMI), as you can see in the chart below.
Longest losing streak for the global PMI
Source: Charles Schwab & Co., Inc. and FactSet data as of 5/3/2019.
China would be especially affected, as softer global demand has weighed on exports, which contracted 2.7% in April from a year ago (Reuters); even though officials seemed to be closing in on a trade deal. Growth of Chinese exports to the United States fell to -13.1% and to Japan to -16.3%, while they slowed down to +6.5% for China’s biggest customer, the European Union (EU). All areas are coming in below the average of recent years.
Year over year growth of China exports
Source: Charles Schwab & Co., Inc. and FactSet data as of 5/8/2019.
The trade deal with China was regarded as a sign of broader improvement in global trade relations. The May 18 deadline is approaching for President Trump to announce a decision on auto tariffs impacting both Europe and Japan. Deterioration in the tone on trade risks is likely escalating investor concerns over tariffs and, potential business disruptions; while continuing to deflate “animal spirits” among business leaders.
China and developed international markets are not alone in facing risks from a breakdown in trade talks—emerging markets (EMs) unrelated to the talks may also be negatively affected. A failure in trade negotiations could lead to a further rise in the U.S. dollar; which could weigh heavily on countries such as India, Malaysia and Indonesia, where a stronger dollar could raise inflation and debt service costs. These countries often suffer during periods of dollar strength, especially when it’s not accompanied by stronger global growth.
With global stocks vulnerable to a pullback, it is fortunate for investors that the trend in the degree to which the world’s stock markets move in sync with each other has been trending lower, as you can see in the chart below.
Diversification is back
Source: Charles Schwab & Co, Inc., Macrobond, and MSCI data as of 4/12/2019. Past performance is no guarantee of future results.
The lower correlation among global stock markets enhances the potential risk-reducing benefits of diversification. This may be especially good news right now since stocks may face heightened risk of a continued pullback (for more read our recent article Diversification: Back After 20 Years).
Some volatility has returned and we believe a pullback in U.S. equities is a healthy development in terms of both investor sentiment and valuations. But some cracks in economic growth may be emerging, and inflation could start to rise given the tight labor market, so investors should remain disciplined with an eye toward rebalancing in the face of volatility. Trade remains a weight on the confidence of business leaders, and if the dispute with China continues to escalate, stocks and the economy would likely suffer further.