HIGHLIGHTS:
- Rising international tensions generated a market response reminiscent of the second quarter.
- What is pushing inflation higher?
- With 90% of companies reporting, S&P 500 earnings are up an impressive 24.4%.
- Turkey becomes the center of attention in an otherwise slow week.
- The Week Ahead: Earnings season winds down but economic reports ramp up.
Rising international tensions generated a market response reminiscent of the second quarter.
The week started off in a positive fashion, and stock indexes continued to edge up closer to the January market highs. Likewise, the yield on the 10-year Treasury note looked ready to break up above 3%.
Then came the news on Friday that President Trump planned to impose even steeper tariffs on Turkey’s fragile economy, as explained below. The market reaction was predictable. First, investors sold stocks, especially international equities, to limit market exposure over the weekend when markets are closed in case the tensions escalate. Second, investors moved to the “safe havens” of the U.S. dollar and U.S. Treasury bonds.
The result was a -0.18% weekly decline in the S&P 500, a larger -1.46% drop in international stocks, and a decline in bond yields, which helped add 0.45% to the Bloomberg Barclays Aggregate Bond Index. The value of the dollar jumped 1.32%. Small cap stocks rose 0.82% for the week benefiting from the rise in tensions and the increase in the dollar.
Via Nova believes the market performance in the latest week was a reminder that the potential risk from international political and trade tensions is not over, despite recent signs of tentative progress. Indeed, the sharper drop in foreign stocks, the rise in the value of the dollar and the outperformance of small caps looked very much like the market in the second quarter. Our most likely scenario continues to reflect that a trade war will be avoided, but that significant progress may not become apparent before the fourth quarter if then.
What is pushing inflation higher?
The Consumer Price Index (CPI) was the dominant economic report in an otherwise light data week. The 0.2% increase was in line with analysts’ expectations, but the CPI rose 2.9% from a year ago, well above the Federal Reserve’s 2% longer term target.
We often think of inflation only in general terms, but the price pressures in the current cycle are not uniform. For the most part, the current inflation push is coming from necessary items and services, while price increases for more discretionary purchases have been well below the overall inflation rate. For example, gasoline prices rose 25.4% over the past year, but we still need to drive to work. Auto insurance costs went up 7.4%. Shelter costs, which make up a third of the overall CPI index, rose 3.5% over the past year. These items are largely unavoidable expenses. In contrast, price increases for more discretionary items have been low. Apparel prices rose a scant 0.2% over the past year. New car prices also edged up 0.2%. Used car prices increased 0.8% year over year.
From a practical investing perspective, the Federal Reserve looks at overall inflation levels when setting policy. Economic growth is healthy, and inflation is rising, which argues for a continued gradual increase in short term rates, and that is our most likely scenario. However, while the increase in interest rates will affect everyone, pricing power among different industries is uneven.
With 90% of companies reporting, S&P 500 earnings are up an impressive 24.4%.
The S&P 500 is putting up very strong profits growth in the second quarter, more than twice the earnings growth rates in European companies, reflecting healthy revenue from a strong economy and higher profit margins from tax reform. Second quarter earnings are expected to increase an impressive 24.4% from the previous year with 79% beating estimates compared to the 64% long-term average. In addition, revenues should rise 9.3% with 71% beating estimates compared to the 60% long-term average.
All eleven S&P 500 sectors in the index expect to see higher earnings from the previous year. The energy and materials sectors have the strongest growth, while the real estate sector is weakest.
The estimated earnings growth rate for the S&P 500 for the third quarter is 22.4%, and fourth quarter earnings are expected to rise 20.4%. Strong earnings growth has been, and continues to be, a key support for the stock market.
Turkey becomes the center of attention in an otherwise slow week.
President Donald Trump stepped up pressure on Turkish President Recep Tayyip Erdogan by tweeting that he would double steel and aluminum tariffs on Turkey. The aggressive move appeared to be prompted by Turkey’s reluctance to to release an imprisoned American pastor, Andrew Craig Brunson, held since 2016. Members of Congress and the Trump administration have objected to Turkey's plan to use a Russian missile defense system. The U.S. also believes Turkey will continue to support Iran after the new sanctions are imposed.
The threat prompted a -13.5% plunge in the value of the Turkish lira overnight and and over -35% year to date. A weaker lira makes repaying foreign denominated debt more expensive. Inflation in Turkey is currently 16%, and the yield on the 10-year Turkish bond surged to nearly 20%. The Turkish economy is very vulnerable at this stage, and this standoff with the U.S. has only exacerbated the problem. So far, the fallout has been limited to European banks that do business with Turkey, and some have had to increase estimated loan losses.
We believe the impact of this Turkey tension on the U.S. and the financial markets will be very limited, though it has helped boost the value of the dollar. The potential casualties, aside from Turkey, could be other emerging markets and the banks that do business with them. We don’t wish to minimize the human importance of this conflict, but the financial impact could be limited. As one news anchor quipped “this could be a slow summer day in search of a story.”
The Week Ahead: Earnings season winds down but economic reports ramp up.
With the good news from earnings season winding down, the market focus will likely turn to economic reports and trade negotiations. The next step on trade is anybody’s guess, but we will see economic updates on a variety of segments, including small business optimism, retail sales, housing, and leading indicators. The July retail sales report will likely receive the most attention. The consensus is calling for a modest 0.1% increase following the healthy 0.5% jump in June.