VIA NOVA UPDATE: Markets up but with a twist

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  • The S&P 500 rose for the week but with different leadership.
  • Strong second quarter GDP growth reflects positive economic backdrop.
  • We are halfway through Q2 earnings season and the numbers are good.
  • The U.S. and EU agree to negotiate trade agreements – a welcomed positive.
  • Big week ahead: FOMC meeting, jobs report, personal income and lots of earnings.

The S&P 500 rose for the week but with different leadership.

The S&P 500 rose 0.61% in the latest week, continuing its trend higher, but without the help of the dominant technology sector.  The economic and earnings data were generally positive, as they have been for some time.  However, perhaps the most favorable factor influencing the markets in the week was a surprisingly good meeting on trade between President Trump and European Commission President Juncker.  Industrial and materials stocks, both dependent on international trade, rallied on the news following recent weakness, as did energy and financial stocks.  International stocks also benfited from the better trade news.  However, the improved optimism on trade weighed on small cap stocks, which have outperformed the S&P 500 so far this year. 

Bond yields rose sharply in the latest week lifting the yield on the 10-year Treasury note to 2.96%.  The higher yields pushed down bond prices, and the Bloomberg Barclays Aggregate Bond Index fell -0.18%, and the index was down -1.76% year-to-date.  In other markets, inflation-hedging investments – real estate, TIPS, oil and gold – all declined.  The value of the dollar moved 0.25% higher for the week.

Strong second quarter GDP growth reflects positive economic backdrop.

The U.S. economy rose at a 4.1% annual rate in the second quarter, the strongest GDP increase since the third quarter of 2014 and well above the 2.3% rate of growth so far in this expansion that began in 2009.  The major segments of personal consumption spending and business investment posted healthy gains.  Our view is that the economy is on sound footing and can grow at or above 3% in the second half of the year.  The key concern for some, though, is that it may not be sustainable given that export growth was likely juiced by one-time, pre-tariff soybean purchases.  However, business inventories fell by a similar amount neutralizing the export surge.  Lower inventories are usually rebuilt, which adds to future growth.  

Inflation picked up to a 3% rate from 2% in the first quarter exceeding the Federal Reserve’s 2% target.  Inflation pressures have risen in recent months, and the question is where those price increases will ultimately land.  Businesses are reporting in surveys that their input costs are rising, but many are saying that they are passing those costs along to customers to maintain profit margins.  We believe the impact of rising costs/inflation will be felt differently by industries and companies, but higher inflation will reinforce the Federal Reserve’s belief that they should continue raising interest rates.

We are halfway through Q2 earnings season and the numbers are good.

The second quarter earnings season is off to a great start.  Over 82% of the companies in the S&P 500 reporting so far have beat analyst expectations compared to a long-term average of 64%, according to Thomson Reuters.  Second quarter earnings are now expected to increase a very healthy 22.6% from Q2 2017, slightly higher than in the previous week.  Almost three-quarters of companies also beat revenue estimates which is above the long-term average.  Profit margins are at record highs, according to FactSet, thanks in large part to the cut in the corporate tax rate.

The U.S. and EU agree to negotiate trade agreements – A welcomed positive

President Donald Trump and European Commission President Jean-Claude Juncker agreed to begin discussions on eliminating the tariffs and subsidies that hamper trade between the two allies, and the markets responded positively. 

The two committed to resolving the steel and aluminum tariffs the Trump administration imposed this year as well as the retaliatory tariffs by the EU.  The package of measures would have the EU buying more liquefied natural gas (LNG) and soybeans from the U.S., and the two sides would begin a “dialogue to reduce differences on regulatory standards between the two economies,” Mr. Trump said.  Autos were not mentioned, however.  The two sides suggested they would hold off on further tariffs—a nod to Mr. Trump’s threats to apply tariffs on imported cars as long as both sides negotiate in good faith.

The result of the meeting was clearly better than expected, but one of the biggest positive potential outcomes, in our view, could be developing a unified front to address common concerns with Chinese trade practices.  The U.S. and the EU agreed to try to use the World Trade Organization (WTO) to deal with issues of intellectual-property theft, government pressure on companies to transfer technology to local partners, and excess capacity in many industries.  If so, it would be a big change in negotiating tactics for the U.S., which until now has relied mainly on unilateral actions against China.

The historic pace of trade negotiations is “glacial.”  The next step is for negotiators from the EU and the U.S. is to hammer out a report in 120 days that will establish the framework for future negotiations.  That deadline is past the midterm elections in November.  Then it would take at least some months to hammer out a trade deal. 

Via Nova’s take on the Trump/Junker meeting is that it helped defuse some of the escalating concerns surrounding trade, a welcomed positive, but it offered few immediate tangibles.  For example, the EU’s commitment to U.S. LNG is more of a future promise than a current reality.  U.S LNG is more expensive than Russian natuaral gas, and the shipping and handling infrastructure for LNG is limited at present.  However, de-escalation is a market positive, and the markets responded accordingly.  Moreover, it is reasonable to think that China noticed the shared commitment to address the need for change in the WTO.  The meeting was a beginning, but it was far from a solution.  We expect to see some progress on the trade front, but we also believe that progress will only come gradually.

Big week ahead: FOMC meeting, jobs report, personal income and lots of earnings.

We are halfway through earnings season, but 141 S&P 500 companies are due to report in the coming week.  Company earnings guidance will be a focus as will any comments on the recent rise in the value of the dollar, cost pressures and trade tariffs, as these two are potentially evolving headwinds for many companies.

On the economic front, the Federal Open Market Committee holds another meeting.  No rate hike is expected, since there was one at the June meeting, but the FOMC’s take on recent events will be of great interest to the markets.  Friday, the all-important jobs report is due.  Analysts are expecting a healthy 200,000 increase in jobs and a slight dip in the unemployment rate to 3.9% from 4.0%.  If the report is this strong, it would help bolter corporate sales and profit expectations, but also put upward pressure on interest rates.