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The Federal Reserve’s first interest rate cut in 10 years was supposed to be met with cheers by financial markets. Wall Street’s response to the 0.25% cut to the target Federal Funds rate on July 31 quickly turned sour. Capital markets, addicted to a decade of cheap money, were not satisfied with a modest cut or the Fed’s language during Jerome Powell’s press conference. The following day, President Trump’s surprise announcement of planned 10% tariffs on an additional $300 billion of Chinese imports marked yet another escalation in U.S.–China trade tensions. China retaliated by introducing a new weapon in the trade war: currency, allowing the exchange rate to dip below 7 yuan per dollar for the first time since 2008. A weaker yuan would make Chinese goods relatively cheaper for U.S. consumers, offsetting the effect of Trump’s promised additional tariffs.
In recent days, protests in Hong Kong and surprise election results in Argentina have fueled geopolitical uncertainty. The resulting spike in volatility and a broad sell-off in risk assets is a test for our aging expansion. These events highlight the inherent fragility in markets and the outlook for global economic growth. While we believe a U.S. recession in 2019 is unlikely, the risks of a domestic slowdown have increased.
Going forward, we view a potential earnings recession for U.S. stocks as a key risk. Stock prices are driven by their earnings (current earnings and future expectations). 2018 saw a tremendous increase in S&P 500 earnings, fueled primarily by the corporate tax cuts of 2017. However, corporate earnings expectations for 2019 began to fade around October of last year. Wall Street estimates for 2019 have continued to deteriorate. The chart below shows the year-over-year change in S&P 500 earnings estimates by quarter, taken at three different points in time: approximately one year ago (8/3/2018), six months ago (1/31/2019), and recently (8/8/2019).
Looking at Q2 2019, the chart shows that one year ago, earnings were expected to grow at 11.9%. Just last week that number turned negative, indicating shrinking corporate earnings. While some of these expectations are factored into current market prices, we believe Q4 2019 results are not fully factored in. The chart shows that analysts have increased their growth estimates for Q4 to 22.0%! In other words, rather than taking down all of 2019 earnings aggressively, analysts have just pushed most of the forecast into the fourth quarter. We see this as a key risk to continued expansion.
Although earnings are slowing, we have not had an earnings recession (negative growth in corporate earnings) since 2015-2016. If an earnings recession does materialize, the downside to stock market performance could be severe and thus warrants continued caution in portfolio allocation.
In a world where a tweet can change the sentiment of the market in a moment’s notice, we think it makes more sense than ever to remain agile and invest in line with your risk tolerance. We will be watching earnings, sentiment, trade tensions and the Fed for clues about what is to come next. For now, at BWM Financial, our tactical portfolios remain slightly underweight equities and overweight fixed income.
Investing involves substantial risk. BWM Financial (the “Firm”) does not make any guarantee or other promise as to any results that may be obtained from the Firm’s “Market Commentary” letter (“Letter”). While past performance may be analyzed in the Letter, past performance should not be considered indicative of future performance. No reader should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.