After rising in lockstep for most of this year-to-date, stocks and bonds moved in dramatically different directions after a week chocked full of market moving developments.
With this week’s latest rebound, the S&P 500 has now closed up or down more than 1 percent 27 times year-to-date ‒ this is more than three times the daily volatility that investors experienced in 2017. Accompanying higher stock prices, safe-haven bonds retreated modestly.
This week we experienced something we haven’t in some time: a down week. Stocks struggled to a close, down 3.8 percent with no help from blue-chip names. Alphabet (GOOGL) and Apple reports weren’t favored by Wall Street, driving the stocks down 5.2 and 4.3 percent, respectively.
The slow creep higher in the markets continued this week. The S&P 500 finished the week up 0.12 percent with financials stocks leading the way, up 2 percent. The ADP jobs report on Wednesday and the nonfarm payroll today gave us “not too hot, not too cold” readings.
Amid the busiest week of second quarter earnings reports, blue-chip stocks continued to trade near record levels. With nearly 40 percent of the S&P 500 companies having reported over the past five days, the clear plurality of results has exceeded expectations.
First quarter earnings season kicked into high gear this week and investors were treated to a smorgasbord of blue-chip results across a range of industries. As they typically do, numbers for most companies have exceeded Wall Street expectations, but with almost 20 percent of the S&P 500 now having reported, the .75:1 ratio of “beats” is modestly better than where it has been over the last several quarters.
Much like January of last year, U.S. stocks are off to a rocky start in the New Year, thanks to a European economy on the verge of stall speed and a plummeting price of oil that’s making investors feel like something other than a small surplus of excess production is afoot. Even after the recent volatility, blue chip stock prices have still tripled since their lows exiting the financial crisis in 2009 and have outperformed international stocks by a whopping 70 percent over the past five years. The question on everyone’s mind is whether a U.S. economy, having now wrapped up what we expect to have been its third consecutive quarter of 3 percent or better growth, can continue to decouple from troubled economies abroad. We still believe that will be the case, as Americans benefit from lower energy prices and a much healthier job market, but positive equity returns in 2015 aren’t likely to come as easily as they did last year.
Banking on Profits?
Our expectation is for U.S. profits to grow by mid-to-high single digit rates in 2015 but, at least for the final quarter of last year, Wall Street expectations are much more subdued. As the fourth quarter earnings season kicks off, investors are expecting earnings to have grown at just a 1 percent clip, reflecting plunging oil prices that will assuredly dent the profits of big oil companies like Chevron and Exxon. What Wall Street may be missing is the positive impact of low oil and natural gas prices on 90 percent of the market’s constituents that are net users of oil and natural gas. While earnings for multi-national companies are likely to be dampened by the stronger U.S. dollar, a clear plurality of publicly traded companies will benefit from lower energy costs that should help boost profit margins.
Regardless of your persuasion, few will argue about the decidedly poor results that banks delivered this week as JP Morgan, Bank of America, Wells Fargo, and Citigroup reported earnings that collectively fell by 12 percent in the period. Unfortunately for investors, the numbers came up short of expectations in all but one case (Wells Fargo), prompting sell-offs in all four names. While lending volumes have picked up in recent quarters, net interest margins are under pressure as deposit costs remain near zero and new loans are underwritten at increasingly low rates. JP Morgan demonstrated that legal costs related to the housing crash remain a meaningful expense item years after the fact, while each of the investment banks reported disappointing results from fixed income, commodities, and currency trading. As reporting season transitions to a broader swath of companies next week, we expect to see more encouraging results.
In a move only mildly surprising to those who have followed its travails in Canada, Target announced this week that it will be exiting the country just two years after its first store opening up north. Having never made a penny there, the general merchandiser’s new CEO Brian Cornell has pulled the plug, acknowledging that management couldn’t foresee profits before 2020. The result of Target’s Canadian misadventures? Nearly $6 billion of accumulated losses and write-downs, equivalent to more than the company’s entire profitability for the past two years combined. Yes, this is what gets CEO’s fired, and is a key reason why prior leader Gregg Steinhafel showed himself to the door early last year.
Our Takeaways from the Week
- Lower stock prices in the New Year reflect worries about flagging growth internationally and dislocations in key foreign currencies
- Fourth quarter earnings season is off to an inauspicious start thanks to disappointing results at four major banks
Despite serious turmoil in the Middle East and ongoing conflict in eastern Ukraine, blue-chip stocks have pushed to new record highs amid upbeat quarterly earnings and encouraging economic data. As Wall Street frets about why interest rates are so low, investors are also enjoying what has turned into a nice coupon-plus return environment for bonds this year, one that could continue to confound those expecting higher rates. Indeed, the CPI report out this week provides evidence that a 2.1 percent inflation rate may trend lower over the next few months if commodity prices continue to moderate.
Gasoline prices accounted for two-thirds of the June index increase, and with pump prices now on their way back down, consumers should expect to get a break at the pump and investors a break on headline inflation. Just as important, natural gas prices have fallen precipitously in the past month due to better-than-expected storage refills and grain prices falling under the expectation of record harvests this fall. With wage gains remaining muted and investment-grade bond yields at surprisingly low levels in Europe, bond investors expecting materially higher rates could be surprised by a rate environment that stays lower for longer. We see an environment of muted inflation and accelerating U.S. economic gains creating a profitable backdrop for equity investors.
A Jobs Renaissance?
Supporting the notion of improving economic fundamentals was this week’s jobless claims number, which breached the psychologically important 300,000 level to the downside. U.S. claims trickled in at a rate of just 284,000 in the past week, a level investors haven’t witnessed in over eight years. This bullish claims number and the downward trending four-week moving average lend credence to the strong payroll numbers reported in June, while increasing our confidence that July’s report will be another good one.
As more people find work, consumption spending should increase, but as the results from McDonalds and its former subsidiary Chipotle Mexican Grill showed this week, where consumers choose to spend their new-found incomes can be as different as, well, burgers and burritos. McDonalds disappointed by reporting falling same-store sales, but Chipotle announced a 17.3 percent surge, the likes of which it hasn’t seen since 2006. Store traffic at the Golden Arches has lagged and McDonald’s contends with a lower income demographic for which pricing is always an issue. In contrast, Chipotle’s higher income constituents are more likely to accept occasional menu price hikes as they did in the second quarter, without chasing away customers. Indeed, Chipotle benefitted from a trifecta of good fortune – higher prices, better mix, and more store traffic that collectively produced 24 percent earnings growth. On much better-than-expected sales and earnings, Chipotle’s stock surged 12 percent while McDonalds’ shares fell 1 percent.
With about half of the S&P 500 having reported second quarter results, approximately 75 percent of companies are delivering better-than-expected earnings, and 65 percent are also besting top-line estimates. As a result, earnings projections for the benchmark index that a month ago predicted 4 percent growth for the quarter now stand at 6 percent.
Our Takeaways from the Week
- Despite stiff geopolitical headwinds, U.S. stocks continue to forge new highs
- A majority of companies reporting so far are delivering better than expected second quarter sales and earnings