Bounce Back

Two Fridays ago, Wall Street got spooked by a poor jobs report. The economy created just 20,000 net new jobs in February while the consensus expected nine times that number. Some are dismissing that as a one-off and not indicative of a souring economy, while others think it is the beginning of more bad news.

A more middling view seems prudent: the economy is still doing well, but not as well. Earnings growth is slowing down. Moreover, we’re currently in the “lull” period between earnings seasons when there’s not a lot of financial or economic news. As such, every news item probably draws undue attention.

Every day, it seems, the market gets jostled by whatever the current headline is on China, North Korea, or Brexit. These issues simply are not likely to be central to the market’s long-term bearing. For investors (as opposed to traders), everything comes down to earnings and interest rates. Beyond that, the rest is mostly noise.

Domestic stocks posted solid gains last week. The tech sector, the largest segment of the S&P 500, performed best, aided by strength in Apple due to enthusiasm over the expected announcement of a new video streaming service. Industrials lagged, weighed down by a sharp decline in Boeing shares following a second fatal accident involving its new 737 Max 8 airliner. The strong performance of tech shares led to the outperformance of the tech-heavy Nasdaq, which became the strongest major index YTD.

Stocks were strong out of the gate last week, helped by expectations that the U.S. and China would soon reach a trade agreement. Traders seemed particularly encouraged by remarks from the head of China’s central bank at a news conference on Sunday, in which he pledged that China would not devalue its currency to boost exports or to use it as a weapon in trade disputes.

Hopes that a deal was imminent faded as the week progressed, however, after Bloomberg reported that the two countries’ leaders were unlikely to meet until at least early April. Growing concerns over the health of China’s economy may have also caused the midweek stall, but news that Chinese officials were responding with new stimulus seemed to be behind a rally on Friday to close the week.

The week’s domestic economic data continued a recent pattern, with the housing and manufacturing sectors flashing warning signals. New home sales dropped nearly 7 percent in January, well in excess of consensus estimates. Overall industrial production failed to rebound in February as much as hoped, manufacturing output declined for a second straight month, and a gauge of regional factory activity fell more than expected. Core durable goods orders (ex-aircraft and defense) jumped in January by the most in six months, however, raising hopes for a rebound in business investment.

Traders also received some hopeful news about the consumer. January retail sales rose a bit, suggesting that December’s plunge, the worst monthly drop since the financial crisis a decade ago, may have been an aberration. The University of Michigan’s preliminary gauge of March consumer sentiment also rebounded more than expected.

China worries, the mixed U.S. economic signals, and a softer-than-expected inflation reading on Tuesday sent the yield on the benchmark 10-year U.S. Treasury note under 2.60 percent, its lowest level since a brief plunge at the start of January, and closed the week at 2.59 percent.

In Europe, the STOXX Europe 600 moved higher last week, boosted by the declining probability that the UK would leave the EU by the March 29 deadline. The week there was dominated by Brexit politics as UK lawmakers voted on a multiple pieces of legislation ahead of the looming deadline. The FTSE 100 rose after UK Prime Minister Theresa May won parliamentary approval to seek a Brexit delay, while the British pound and the euro also gained against the U.S. dollar.

Chinese stocks also rose last week, buoyed by assurances of economic support from a top official after several indicators underscored the country’s continued slowdown. For the week, the Shanghai Composite rose 1.74 percent and the large-cap CSI 300, considered China’s blue-chip index, added 2.39 percent. Most of the gains came on Friday, when Chinese Premier Li Keqiang said that Beijing was considering cutting some interest rates and banks’ reserve requirements to bolster economic growth. Li also stated that Beijing was keen to help the real economy, particularly small and private businesses, to bolster employment and prevent large layoffs. Elsewhere in Asia, Japan’s Nikkei 225 was up 2 percent.

Other significant news and notes follow:

• British lawmakers voted to postpone the country’s departure from the EU, but narrowly failed to wrest control of the Brexit process from Prime Minister Theresa May’s government. The Brexit endgame (a visual guide). And with time running out until the UK is slated to trigger Article 50 and leave the EU, SEC Chairman Jay Clayton told a group of international bankers last week to brace for price volatility.
• Germany seems headed toward a significant slowdown in growth and perhaps into a recession. Which route the country takes has major implications for Europe and the rest of the world. After recording zero growth in the fourth quarter of 2018, narrowly avoiding back-to-back quarters of economic contraction (the common marker for recessions), one of Germany’s most prestigious research institutes Thursday cut its expectations for German growth this year by almost half.
• “We’ll have news on China. Probably one way or the other, we’re going to know over the next three to four weeks,” President Trump told reporters. He added that China had been “very responsible and very reasonable.” But a final agreement is still far from a sure thing. Treasury Secretary Steven Mnuchin said that a proposed meeting between Mr. Trump and President Xi Jinping of China won’t happen this month because there is still more work to do. Some think it could happen in April.
• Extrapolating if/when the world’s second-biggest economy will overtake the first is a tricky business riddled with caveats.
• The Senate joined the House and voted to overturn the President’s national emergency declaration about the border. As expected, the president vetoed it.
• Despite a campaign promise to end federal debt, President Trump’s budget projects trillion-dollar deficits for the next four years, and no balanced budget for at least 15, despite assuming consistently strong economic growth and no recession going forward.
• President Trump said the Federal Aviation Administration would ground Boeing’s fleet of 737 MAX airliners in a major safety setback for the plane maker after two deadly crashes in less than five months. It was inconvenient for air travelers too.
• President Trump’s former economic adviser, Gary Cohn, speaking on the Freakonomics podcast, said that Mr. Trump’s trade adviser, Peter Navarro, is in his view the only Ph.D.-holding economist in the world who thinks that tariffs do not hurt the economy.
• Friday marked a quarterly collision that traders call “quad witching,” when equity and index futures and options expire. Adding to the fun, dozens of S&P indexes were scheduled to rebalance their holdings at the end of the day. That means ETFs and other index traders will realign their portfolios to match their updated benchmarks, buying shares that have been added and selling stocks that have been dropped. By some estimates, ETFs will need to complete $100 billion in combined buying and selling.
• Economists have lowered their forecasts for U.S. employment and economic growth in the first quarter.
• Howard Marks and Oaktree just waved a big warning flag to credit markets.
• Yale’s asset allocation bears no resemblance to the typical university endowment.
• Envestnet to buy MoneyGuide for $500 million.
• Shake Shack tests four-day work week amid tight U.S. labor market.
• At least 49 people were killed in Christchurch, New Zealand after gunmen opened fire on two mosques. Dozens more are injured, many of them seriously, and the death toll is expected to rise. Three men and one woman have been arrested, with one man, 28, charged with murder. Witnesses say the man strolled in and opened fire on innocent worshipers. Prime Minister Jacinda Ardern said it was a well-coordinated attack and called this “one of New Zealand’s darkest days.” An 87-page manifesto believed to belong to one attacker also has emerged, filled with anti-immigrant and anti-Muslim rhetoric.
• Some states want to require that financial advisors act in clients’ best interests, perhaps clumsily.
• Federal prosecutors are pursuing a criminal investigation into deals Facebook made with “at least two” large smartphone makers to access user data like friend lists and contact information, without explicit consent from its users.
• The bomb cyclone hit hard.
• Peak California.
• Banks and money-laundering.
• Almost 80 investment advisory firms agreed to pay back more than $125 million to clients who were steered into higher-cost mutual funds without being clearly told about cheaper versions.
• Before the 2008 stock market crash, 52 percent of Americans aged 35 or younger were invested in the stock market. As of last year, the number had dropped to 37 percent.
• Consider high-school teacher Donelan Andrews, perhaps the first person ever to read his insurance policy.

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Losses Everywhere

The major domestic equity benchmarks ended last week lower, with the large-cap indexes holding up substantially better than the tech-heavy Nasdaq and the smaller-cap benchmarks. Trading volumes were elevated, especially later in the week, and the VIX jumped to its highest level since April. Within the S&P 500, energy shares were among the best performers, boosted by a rise in oil prices, as traders braced for the implementation of new sanctions on Iran in early November. Financials shares also outperformed, helped by a surge in longer-term interest rates, which bodes well for bank lending margins. Utilities stocks, which typically perform poorly as rates rise, were among the week’s best gainers as they seemed to benefit from a general migration to more defensive stocks. The strong relative performance of the three sectors helped slower-growing value shares easily outperform higher-valuation growth stocks for the week.

Consumer discretionary shares lagged due to weakness in Amazon, which now makes up roughly one-third of the sector, following the transfer of fellow internet giants Netflix and Facebook to the new communication services sector. Amazon shares fell in the wake of news that it had raised its internal minimum hourly wage to $15 and a Bloomberg report — disputed by Amazon — that the company’s servers had been hacked by the Chinese military through the use of tiny chips implanted in motherboards. News of the possible hack also seemed to derail a rally in the shares of Apple, which also denied the alleged penetration of its servers.

Markets got off to a solid start for the week following the announcement that Canada had joined the U.S. and Mexico in a revised North American Free Trade Agreement, now to be known as the United States-Mexico-Canada Agreement, or USMCA. Traders noted that the sharp gains Monday morning probably reflected a thirst for any signs of trade progress, but the larger issue of trade with China still loomed in the background and seemed to take the air out of the rally Monday afternoon. Tensions with China appeared to escalate late in the week after Vice President Mike Pence gave a speech harshly criticizing Chinese trade policy and accusing China of attempting to interfere in U.S. elections.

The week’s most notable development for both the stock and bond markets was the sharp increase in longer-term interest rates. The yield on the benchmark 10-year U.S. Treasury note jumped from 3.06 percent at the end of trading the previous week to 3.25 percent in intraday trading Friday, its highest level since the summer of 2011. The biggest move occurred Wednesday and appeared to be sparked by an interview with Federal Reserve Chairman Jerome Powell, in which he described the economy as “firing on all cylinders.” U.S. economic data released Wednesday seemed to confirm Powell’s comments. In particular, the Institute for Supply Management’s gauge of service sector activity jumped to its highest level since the Institute began collecting data a decade ago. The ADP monthly report on private sector payroll gains also came in higher than expected.

The government’s official payrolls report, released Friday morning, was mixed but failed to reverse the increase in bond yields. The Labor Department reported that employers added 134,000 jobs in September, the smallest gain in a year. However, the unemployment rate fell to 3.7 percent, its lowest level in nearly five decades. However, there are at least two caveats to the headline number in the details of the report. First, Hurricane Florence appeared to be partly responsible for the drop in payroll gains, particularly due to a decline in employment in the leisure and hospitality industries. Second, the previous two months’ gains were revised substantially higher. Nevertheless, the report seems to indicate that the gradual cyclical moderation in the labor market that began in 2015 has resumed.

Overseas, European stocks followed U.S. equities lower amid a rise in global bond yields and continued worries about the Italian government’s spending plans. For the week, both the pan European STOXX Europe 600 Index and the FTSE MIB Index dropped 1.8 percent. In Asia, Japanese stocks were down along with most of the world. Mainland Chinese stock markets were spared by being closed for the week-long National Day holiday, but trade tensions loomed in the background as Beijing said it would cut tariffs on a wide range of products to soften the impact of U.S. tariffs.

Other news and notes follow.

• Fed Chairman Jerome Powell said tax cuts and spending increases could hobble the government if it has to respond to a downturn.
• However, “There’s no reason to think this cycle can’t continue for quite some time, effectively indefinitely,” Powell said later last week.
• Federal spending has ballooned in recent years, but comparatively less money has been spent on public goods — things like national defense, basic scientific research, and roads. Many think that more spending on public goods would be a good thing. The problem is in deciding which public goods are “good.”
• The U.S. and Canada reach a new trade agreement.
• Two-thirds of business economists in the U.S. expect a recession to begin by the end of 2020.
• Third quarter earnings season is quickly approaching. Ninety-eight companies have commented about upcoming results and 76 percent of these preannouncements have been negative.  Historically, about 71 percent of preannouncements are negative.
• The S&P 500 has never dropped in the year after midterm elections since the 1946 cycle — and has climbed 15 percent on average — regardless of which political party won or lost control of Congress.
• About 44,000 Verizon employees, or more than a quarter of the company’s workforce, were offered voluntary severance packages last month, as the carrier sought to cut $10 billion in costs and upgrade to a faster, 5G network.
• U.S. Treasury ETF total returns since the all-time 10/30 year yield lows in July 2016: 1-3yr (SHY): -0.2%; 3-7yr (IEI): -3.8%; 7-10yr (IEF): -8.1%; 10-20yr (TLH): -11.0%; 20+yr (TLT): -15.5%; and 25+yr STRIPS (ZROZ): -22.2%.
• Amazon increased the minimum wage for all its U.S. workers to $15 per hour.
• The ISM manufacturing report continues to show robust factory activity across the U.S. The headline ISM index remains near multi-year highs.
• Nearly $3 billion flowed out of government-bond funds during the week ended September 26, the largest weekly outflow since November 2016, according to a Bank of America Merrill Lynch analysis of EPFR Global data.
• Netflix shares have surged 99 percent this year and are the third-best performers in the S&P 500, behind those of chip company Advanced Micro Devices and medical-device company Abiomed.
• 95 percent of Americans own a cellphone, while 77 percent own a smartphone. 89 percent of Americans use the internet; 69 percent use social media.
• After rising 7.7 percent in the third quarter, the S&P 500 has now shown positive gains in 21 out of the past 23 quarters going back to the start of 2013. Since Q2 2009, the S&P is up 32 out of 38 quarters.
• Ten years ago last week, in the depths of the financial crisis, President Bush signed into law a $700 billion plan to rescue the U.S. financial system.
• Eighteen years ago, GE was viewed as a company that could do no wrong. It was the largest company in the world. Its management was viewed as nearly omnipotent and every organization attempted to emulate it. It was the most widely followed and was the most recommended stock in history. Its AAA rating was sacrosanct. Today it is a shadow of itself, down about 82 percent in value from its apex, viewed by many today, at best, as a “speculative buy.”
• Consumer confidence is surging. Consumer spending is solid. The holiday shopping season is expected to be strong. But mall vacancy rates rose to 9.1% in the third quarter, their highest level in seven years.

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Mostly Flat and Quiet

Above is an amazing chart from Bank of America Merrill Lynch showing the various bearish narratives that have evolved over the course of this long bull market. The market was undecided on a narrative last week as the major domestic equity benchmarks generated mixed performance, with large-caps outperforming small-caps and the tech-heavy Nasdaq. The busiest week of second-quarter earnings reports saw a modest pickup in trading volumes, particularly on Thursday. Industrials outperformed as trade tensions eased somewhat, and airline stocks rallied on healthy passenger volumes. Communications and media stocks suffered following a plunge in Facebook shares on Thursday, but the damage to the larger tech universe was generally contained.

Last week’s most notable event was probably Facebook’s dramatic drop. It’s not every day that you see “the largest ever loss of value in one day for a U.S.-traded company,” but Facebook, which lost as much as $151 billion of market capitalization in overnight trading after announcing disappointing growth numbers and guidance, claimed that record by ending Thursday down nearly 19 percent, wiping out more than $119 billion in value. Within that is a $15 billion hit for founder and CEO Mark Zuckerberg. The stock fell back only to levels reached in April, however, and Facebook remained the fifth most valuable company in the world.

Traders appeared to react primarily to growth in Facebook’s revenues in the quarter that was slower than some hoped for, as well as plateauing growth in daily active users in some key markets. The company also warned that rising expenses, partly to deal with privacy concerns, would reduce profit margins in the coming quarters. Facebook’s drop in market cap would have wiped out the capitalization of number of other tech companies including Texas Instruments, Broadcom and Salesforce, as well as 457 of the companies in the S&P 500 overall. That said, Facebook earnings were objectively excellent, up 32 percent year-over-year, with revenues up 42 percent (and up 11 percent quarter-over-quarter).

Amazon announced second-quarter profits of $253 billion, up from $197 million a year earlier and its first ever $2 billion quarter. This marks three straight quarters of profits above $1 billion and extends Amazon’s profitability streak across three years. Fast-growing areas including the cloud-computing business and advertising offerings raised Amazon’s profit margin to its highest in years, offsetting its lower-margin traditional retail business, which still provides the bulk of revenue. Despite the good news from Amazon, the pressure on internet and tech firms continued Friday, with Intel and Twitter also suffering large declines.

Inigo Fraser-Jenkins is the Sanford C. Bernstein & Co. analyst who put out the (in)famous note back in 2016 claiming that passive investing is “worse Than Marxism.” Last week his “greatest hits” file took on an addition when he argued that Amazon is well positioned to shake up the asset management industry. The trouble with this sort of speculation (it may be true, but there is not yet any evidence to support it) is that it’s essentially true about any industry – Amazon may get into it. But Fraser-Jenkins got a good bit of publicity, which was almost certainly the point.

Last week brought mixed news on the trade front. President Trump and European Commission President Jean-Claude Juncker turned down the heat on trade Wednesday, suggesting the U.S. and the European Union would hold off on further tariffs while they talk through their differences. The sixty-three-year-old former Prime Minister of Luxembourg craftily packaged together a number of small concessions and previously agreed upon initiatives which allowed Mr. Trump and his allies to hail the agreement as an American win. The surprise truce is the first major sign Mr. Trump is open to the sort of ambitious market-opening negotiations that his aides have talked about. The deal is still contingent on good-faith negotiations, of course, and there is no schedule set to complete the talks. Of course, critics say that Mr. Trump was taking credit for solving a problem he caused.

Conversely, tensions between China and the U.S. appeared to sharpen last week. Chinese regulators refused to grant approval to the proposed merger of U.S. semiconductor maker Qualcomm and Dutch competitor NXP, a move that many observers expect will prompt retaliation from the U.S.

Last week’s economic data remained generally favorable. On Friday, the Commerce Department reported that second-quarter gross domestic product had expanded by 4.1 percent versus a year earlier, roughly in line with expectations but very good news and the biggest jump in four years. Business inventories unexpectedly declined outright, applying a one percent drag on second-quarter growth — a liquidation that was probably an unintended consequence of surprise demand strength, particularly in consumer spending and in goods exports. Outright inventory liquidation is unusual outside of recessions, and the drawdown left inventories at very low levels relative to sales, making a return to accumulation likely.

News that Japan and other central banks might be preparing to tighten their monetary policies sent longer-term U.S. Treasury paper yields higher at the start of the week. Prices remained lower at week’s end.

European stocks had a good week, fueled by strong corporate earnings results and the good trade news. The pan-European STOXX 600 rose by nearly 0.5 percent to its highest level in more than a month. So far this earnings season, about 56 percent of STOXX 600 companies surpassed earnings-per-share estimates. The weaker euro in the second quarter has contributed to a higher proportion of companies topping sales expectations versus the first quarter. Germany’s DAX 30 notched its highest close since mid-June, reversing its fall earlier in the week that was largely due to trade worries. The UK’s blue chip FTSE 100 closed up nearly 0.5 percent too.

Worries about spreading protectionist policies led Japan and the EU to sign a broad-based, free-trade pact. The deal represents a trade zone that encompasses roughly one-third of global GDP. The deal required a series of significant concessions, which will eventually remove the 10 percent tariffs on Japanese cars and auto parts sent to the EU. It also eliminates tariffs (of 15-30 percent) on wine, cheese, and other European foods shipped to Japan. The trade pact still needs approval from both parliaments before it becomes law. At a news conference after the signing ceremony, Japanese Prime Minister Shinzo Abe said, “There are rising concerns about protectionism, but I want Japan and the EU to lead the world by bearing the flag of free trade.” Some believe that Abe’s push for the Japan/EU agreement is part of a broader effort to help avert the U.S./China trade war escalation and to insulate Japan from a possible global economic slowdown if protectionist policies escalate.

The Chinese yuan posted its seventh straight weekly loss on Friday in its longest losing streak since 2015 as the deepening trade rift with the U.S. kept downward pressure on the currency. The yuan’s drop against the dollar has accelerated since mid-June. The decline occurs as U.S. tariffs on billions of dollars of Chinese goods are set to become effective in August and coincides with a broader economic slowdown as Beijing tries to de-risk the country’s financial system. The yuan fell 1.71 percent in this year’s first half. The yuan’s weakness — which should make Chinese exports cheaper and thus more attractive in world markets — has raised speculation that Beijing is allowing the currency to weaken as a way to soften the economic blow from U.S. tariffs. Earlier in July, U.S. Treasury Secretary Steven Mnuchin told Reuters that the Trump administration would “very carefully review whether [China] has manipulated the currency.”

Finally, according to a Bank of America Merrill Lynch research note, the so-called FAANG stocks — Facebook, Amazon, Apple, Netflix and Alphabet (Google) — were single-handedly responsible for the S&P 500 being positive through the first half of 2018. Without them, the index’s first half performance would have been -0.73 percent.

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