“One swallow does not a summer make, nor one fine day,” as Aristotle once said.
The U.S. labor market saw the best jobs growth of the year in June, but markets are still seeing a 100% probability of an interest-rate cut at the Federal Reserve’s next meeting, set for July 30-31, and these hopes are helping to drive stocks to record highs.
Despite Friday’s pullback in stock prices on the better-than-expected payrolls data, the blue-chip Dow DJIA, -0.16% ended the week up 1.2%, the S&P 500 index SPX, -0.18% was up 1.7%, and the Nasdaq Composite index COMP, -0.10% rose 1.9%, leaving all three benchmarks within striking distance of all-time highs.
“The jobs report is reassuring investors that the domestic economy is solid,” Alec Young, managing director of global markets research at FTSE Russell, told MarketWatch. Nevertheless, he still expects the Fed to cut interest rates as “insurance,” in case data on the U.S. economy start to take a serious turn for the worse.
U.S. payrolls increased by 224,000 in June, according to the monthly Department of Labor report released on Friday, recovering from May’s weak result of 72,000 jobs created, but employment growth in 2019 has averaged 172,000 jobs per month, well below 2018’s average of 223,000 per month, suggesting U.S. economic growth may be at least reverting to the mean after last year’s boost after the Trump tax overhaul in late 2017.
“To find any justification for this cut, you have to look globally,” Young added, arguing that slowing global economic growth, combined with unconventional monetary policy in Europe and Japan, have caused global investors to flock to U.S. government bonds, with the U.S. 10-year Treasury TMUBMUSD10Y, +0.00% since May yielding less than the target federal funds rate of between 2.25% and 2.5%.
Labor-market data tend to be a lagging indicator, while more forward-looking data still suggest U.S. economic growth is weakening as Trump’s approach to trade policy undermines business confidence and spending globally.
Outside of the labor market, economic data have deteriorated significantly. In June, IHS Markit’s manufacturing index fell to 50.1, the worst reading since 2009, while the ISM manufacturing index fell to its lowest reading since late 2016 with a slump to the 51.7 mark. Any number above 50 is considered an expansion in factory activity, but the manufacturing gauge has dropped steadily since mid-2018.
Trade war warrants worry
Stock markets rallied earlier in the week on news that Trump and Chinese President Xi Jinping had agreed to a restart of trade negotiations and an upping of Chinese purchases of U.S. agricultural products, while the U.S. pledged to not implement new tariffs and to allow U.S. technology companies to sell some goods to Chinese telecom giant Huawei Technologies Inc.
But details as to the nature of the reprieve remain lacking, and, while there are reports that American negotiators will visit Beijing in the coming week, the path to a deal is unclear. Beijing has given no details as to the timing and magnitude of any new agricultural purchases, while Ministry of Commerce spokesman Gao Feng said last Thursday that a deal could only be reached if the U.S. agrees to remove all tariffs — at odds with the American position that some tariffs must remain in place to ensure Chinese compliance.
“The Trump administration’s willingness to actively use trade barriers as a tool of broader foreign policy remains a key risk to monitor despite the agreement to a second truce between the U.S. and China on trade negotiations,” J.P. Morgan analyst Bruce Kasman wrote in a research note. “The business-sector response to this approach, rather than the direct impact of higher tariffs, poses the greatest threat to global growth, in our view.”
Spending by U.S. companies on plants and equipment also looks to be slowing as the impact of last year’s tax cuts wears off and trade disputes with China undermine confidence. Morgan Stanley’s index of expected capital expenditures by American companies dropped to its lowest level in two years last month. Weakening capex growth comes after an increase last year, when a Republican tax bill lowered the corporate tax rate from 35% to 21%, triggering a jump in corporate investment, in the view of Morgan Stanley chief economist Chetan Ahya.
A trade-war effect is showing up in industry data. General Motors Co. GM, +0.89% and Ford Motor Co. F, +0.00% last week said their quarterly sales in China fell. GM’s vehicle sales in China for the June quarter dropped 12.2%, while Ford’s sales slumped 21.7%. For the first quarter of this year, Ford’s sales in China tumbled 35.8% as GM’s skidded 17.5% lower.
The slowdown is hitting the U.S. trucking industry, also. After a stellar 2018, trucking shipments have plunged during the past six months, according to the Cass Freight Index. More and more data indicate “that this is the beginning of an economic contraction,” said Donald Broughton, founder of Broughton Capital and the lead analyst for the Cass Freight Index.
Earnings growth ebbing
U.S. companies will report second-quarter earnings later this month, giving investors a clearer picture of the health of the economy. Earnings per share contracted in the first quarter, and analyst estimates based on companies’ forward guidance foresee a further drop for the second quarter, according to FactSet data.
“Actual corporate profits for all corporations peaked in the third quarter of 2018, according to the GDP report, at $2.321 trillion,” said Ned Davis of Ned Davis Research. “They fell to $2.311 trillion in the fourth quarter and fell to $2.252 trillion in the first quarter of 2019.”
Yet U.S. stock benchmarks hit all-time highs last week, even as bond yields fell to levels typically signaling a forthcoming recession.
The apparently contradictory phenomena may perhaps be explained by corporate stock buybacks that are helping to power an equity-market rally and masking an economywide fall in corporate profits for nearly a year, according to Davis.
Operating earnings per share, however, for the S&P 500 index have continued to climb as a result “of a lot of creative accounting, including massive buybacks,” Davis added.
In the 12 months through March 2019, corporate stock buybacks totaled $823.2 billion on some $1.129 trillion in earnings. For the same period the year before, buybacks totaled $575.3 billion on earnings of $986.5 billion. U.S. companies bought back $4.7 trillion of their own shares from 2009 through 2018, according to S&P Dow Jones Indices.
Read: Gap between S&P 500’s gains and disappointing U.S. data largest on record
Powell and a possible tantrum
Faced with what Jerome Powell, the Federal Reserve chairman, has called “crosscurrents” from Trump’s trade war hitting recent economic data and corporate results, markets widely expect the central bank to cut interest rates later this month.
The danger is that any failure to deliver on lower rates could spark a market tantrum similar to the so-called taper tantrum of 2013, which triggered a spike in U.S. Treasury yields after investors learned the Fed was putting the brakes on its quantitative-easing program.
Powell’s semiannual testimony to Congress on Tuesday of this week and the publication on Wednesday of the minutes of the June FOMC meeting may provide additional clues.
“A rate cut in July is still all but inevitable,” wrote Luke Bartholomew, investment strategist at Aberdeen Standard Investments. “Employment growth remains a bright spot amid a fairly mixed bag of U.S. data, and yet markets have come to expect a cut now, so will fall out of bed if they don’t get one.”
But at the June Fed meeting the median forecast by Fed officials was for no rate cuts in 2019, and some voting members of the Fed’s interest-rate-setting committee, such as the bank’s vice chairman for supervision, Randy Quarles, have publicly taken aim at any justification for a rate cut.
“The level of certainty [that the Fed will cut in July] is not justified,” said John Vail, chief global strategist at Nikko Asset Management, in an interview, pointing to recent comments by Federal Reserve Vice Chairman Richard Clarida, who said in June that the central bank can’t be “handcuffed” by the markets.
Still, Vail admitted that stock markets appear to believe they can still expect a rate cut. “At least in the short term, markets believe they can have its cake and eat it too,” he said.
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