The prospect of peak earnings, some cooling economic indicators, high valuation pockets, and a more hawkish/tightening Fed drove U.S. equity markets into correction territory last week which, as we’ve stated many times, happens every 18 months on average. While the volatility is likely to continue, we do feel this this is more likely a healthy correction than a sustained bear market. Earnings, economic, and policy (monetary/fiscal) will ultimately drive market returns.
- U.S. stocks fell 3.5%-4.5% last week as the S&P 500 entered correction territory, pushing the index to a slightly negative return for the year. October’s -8.8% decline thus far is on pace for the biggest monthly drop since Feb 2009.
- Both swiftness (24 days) and size (-9.3%) of the drawdown have been notable. In the history of the S&P 500, declines of over -7.5% in less than five weeks has happened only 19 times. Thus far in October, over 78% of days have closed in the red from the prior day. April 1970 (81.8%) was the last time we had a month with a higher percentage of negative closes.
- Toward the end of the week, traditional risk aversion trades began to take shape for the first time during the correction. Euro IG CDS (43 to 80), USD (52wk high), 2yr UST (1mo low).
- High yield spreads have widened in sympathy with the equity market (325 9/21 to 372 10/26) but remain extremely tight from a longer-term perspective.
- Short term technical picture is firmly in oversold territory with only 10.1% of stocks trading above their 50-day moving averages. Longer term is mildly oversold with 32.1% below their 200-day moving averages.
- With 48% of S&P 500 companies reporting, 3Q blended earnings growth is 22.5% (67% beat rate) is encouraging. However, revenue (56% beat rate) and flat guidance have been problematic.
- ECB chief Mario Draghi caught markets a bit off guard on Thursday because he didn’t provide his usual dovish narrative routine but rather reinforced terminal year end QE target and upbeat Eurozone economic/inflation projections.
- Markets have begun to price in a more dovish Fed as evidenced by odds of a December hike falling from over 90% to 67% today and odds of two 2019 hikes at less than 14%.
- Brazil and China were the only two global equity markets in the black last week. Chinese policy makers rolled out tax cut stimulus trigger household spending. 2019 fiscal stimulus is now up to 1% of GDP and 3m credit growth has climbed from 8% to 15% over the past several months.
- China’s overall ability to levy adequate stimulus is up for debate. Total debt/GDP has ramped from 140% to 260% over the past 10 years, abandoning the reform agenda risks undermining credibility, and excessive fixed asset investment has resulted in tangible overcapacity issues.
Economic Release Highlights
- Third quarter GDP beat expectations at 3.5% backed by robust consumer spending growth of 4% (Q2 3.8%) which contributed 2.7% to GDP, strong 3.3% growth in government spending which contributed 0.6% to GDP, and a material $76.3b rebuild in inventories which contributed 2.1% to GDP. Business investment, housing, and trade deficit data were disappointing.
- Business investment slowed to 0.8% growth after 8.7% and 11.5% in Q2 and Q1, hinting at a potential fade of corporate tax cut effects.
- Residential investment fell 4%, the fifth contraction of the past six quarters - a reflection of the weakening housing sector.
- A steep increase in the trade deficit to $99b pulled 1.8% off the headline GDP number, the largest detract from trade in 33 years. Imports surged 9.1% and exports posted their first contraction (-3.5%) in 2 ½ years.
- September single family home sales fell 5.5% and median sale price decreased 3.5% y/y to $320,000 while supply rose to 7.1 months from only 5.3 months last September. The one good data point was pending sales rose 0.5 percent in September, the high end of estimates.
- Mid-month flash PMI (+1.4 to 54.8) showed firming growth across manufacturing (55.9) and services (54.7) samples. Input costs marked a 5-year high amid reports of pass through to customers.
- September headline durable goods report was encouraging at 7.9% y/y growth, but the ex-transportation data point showed only a 0.1% increase and a -0.1% decline in core capital goods orders paints the picture of a flattening in business investment.