Our Top Market Takeaways for the week ending October 18, 2019.

Markets in a minute

We have good news and bad news

This week, much of our attention was occupied by two things: Brexit developments and the start of the third-quarter earnings season in the United States.

In the case of Brexit developments, here’s the good news: UK and EU negotiators have, at long last, agreed upon a (new) draft deal for the United Kingdom’s scheduled October 31 withdrawal from the European Union. The development marks meaningful progress, and suggests that the three-year-long Brexit saga may finally have an end in sight. Alas, there’s bad news: It’s not a sure thing yet. The deal still needs to be approved by a majority of the UK parliament, and that’s proven to be no cake walk—former Prime Minister Theresa May attempted and failed three times to achieve such a feat. It doesn’t help that the 10 seats representing Northern Ireland’s Democratic Unionist Party have made it clear they won’t vote for the deal. That’s not to say it’s impossible, however, as Prime Minister Boris Johnson may be able to aggregate enough votes through a coalition of his Conservative Party and others.

Recent gains in the UK pound (up almost +4.0% versus the U.S. dollar in the last week) tell us that markets are hopeful that a deal may be reached before the October 31 deadline. Otherwise, it’s possible that Prime Minister Johnson kicks the can further down the road by requesting another Article 50 extension. We should have more clarity by the end of the weekend.

With an eye on profits, let’s start with the bad news: As the third-quarter earnings season ramps up, analysts are pretty pessimistic about S&P 500 company earnings. Consensus expectations are for profits per share to contract by around 4% versus a year ago. Why the downtrodden outlook? For one, the comparisons to last year are tough.

Recall that one year ago, U.S. corporations reaped the benefits of the Tax Cuts and Jobs Act and enjoyed a surge in earnings as a result. Today, that makes for a particularly tough year-over-year comparison. Also, headwinds, including trade uncertainty, faltering CEO confidence (and weaker capital spending on things like technology, machinery and other equipment), and an inventory overhang from 2018, have kept a lid on growth prospects this year.

Sheesh, so what’s the good news? Well, for starters, we think things will turn out better than the market is expecting this quarter. Since 2014, S&P 500 companies have beat analyst expectations by an average of ~4.9%. We wouldn’t be surprised to see 3Q19 results beat expectations by a similar amount, which would suggest actual profits per share end up closer to flat (0%)—still not great, but better than negative. This week left us more hopeful that things may indeed shake out this way, as results so far have been fairly upbeat. But it’s still early, and we’ll be watching as a slew of earnings releases are announced in the next few weeks.    

Spotlight

Three charts that really matter

From time to time, we like to share a few pictures that we think tell powerful stories. This week is one of those times.

1. A.I. = After Inversion

In August, a popular recession indicator flashed red: The yield curve inverted. Following yield curve inversions in 1988, 2000 and 2005, the economy suffered recessions within about two years—yikes. This time around, we’re less concerned, and here’s why:

The yield curve is actually pretty simple: It represents the cost to borrow at different maturities. Generally, it slopes up-and-to the-right-ish because lending money for short periods of time tends to be less risky than lending money for long periods of time… so yields (or the cost to borrow) go up, the longer the maturity.

This can all change later in the cycle when the Fed wants to slow growth down in an effort to prevent inflation or asset bubbles. By hiking short-term rates, borrowing becomes more expensive. This in turn causes long-term rates to fall in anticipation of lower future growth. So the curve becomes flatter, and possibly even inverted.

But much like hitting the brakes on a large cruise ship, monetary policy works with a long lag. This makes it difficult for central bankers to fine-tune policy, and they often over- (or under) tighten policy. The chart below shows that in 1988, 2000 and 2005, the Fed kept hiking for months after the curve inverted. This time, the Fed has already cut rates since August, and we expect more to come.

Why we care? Investors with long-term goals should stick to their investment plans and worry less about frantic news around the curve. A nimble and vigilant Fed likely made adjustments in time to keep the cycle alive.

The chart shows the change in the fed funds rate six months after yield curve inversion during the past four times the curve was inverted. It shows that in December 1988, February 2000 and December 2005, this was followed by an increase in the fed funds rate. However, in August 2019, the yield curve inversion was followed by a decrease in the fed funds rate.

2. An Interesting Angle on Trade

This chart from J.P. Morgan Asset Management’s Guide to the Markets caught our eye. It depicts “goods exports” as a share of GDP. In other words, how much does any particular country rely on selling its goods to the rest of the world?

Perhaps unsurprisingly, Taiwan is among the most reliant on exports, with 57% of GDP attributable to goods exports. China clocks in at 19%, with the United States being its single largest customer. In Europe, 20% of GDP comes from exports (Germany is its biggest exporter, accounting for ~35% of the total). So what about the United States?

It turns out that goods exports comprise only ~8% of U.S. GDP—by far the smallest of the countries listed. Why we care? As the trade war continues to create uncertainty, weigh on sentiment, and contribute to a manufacturing slowdown, we continue to see the United States as comparatively resilient. While we think a deal will eventually get done, we continue to like the United States as a destination for investment capital, and we remain overweight U.S. equities in our managed portfolios.

The chart shows exports as a percentage of GDP for various countries, which illustrates how trade is more important to some countries than others. For example, exports are a small share of U.S. GDP, but are a large share for countries like Korea and Germany. For each country, percentage of GDP is further divided by the country the goods are exported to, including China, Emerging Markets excluding China, United States, European Union, and other.

3. Secular Opportunity vs. Cyclical Fears

Think back to 2006, and imagine an investor named “Billy.” As a very perceptive investor, Billy worried that a bubble in credit and housing could cause a recession—and possibly even a crisis. At the same time, Billy was intrigued by a fast-growing company called Amazon. Amazon was making bold moves in e-commerce and disrupting the traditional “brick and mortar” retail model. But with a recession looming… was it really a good time to buy?

Hindsight is always 20/20, but obviously he should have bought the stock. In fact, an investment in Amazon would have returned +5,200% if Billy bought it a year prior to the market’s peak. This imaginary scenario is intended simply to make us think: Will investors miss some great opportunities in secular growth areas over fears of recession and political “what-if’s”?

While there is no way of knowing what company (if any) will be the next Amazon, at J.P. Morgan, we have several high-conviction growth ideas. One such area relates to the intersection of data, technology and software. As shown below, data traffic is expected to grow between 20% and 40% annually in the coming years—wow!

Why we care? As “big data” usage by companies proliferates, the ability to store, protect and analyze that data should pave the way for exciting opportunities in data storage, cloud computing, cybersecurity, artificial intelligence, and more. We hope you’re listening, Billy.

The chart shows the projected increase in data traffic from known 2017 exabytes per month to estimates for 2021. CAGRs globally are around 20% and above for this timeframe.

All market and economic data as of October 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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