It’s hard to take a step back on a day when the Dow Jones Industrial average closed down more than 700 points (and 3.10%), but that’s exactly what I’m going to suggest.
The huge sell off was driven by three major factors in my opinion.
First, the U.S. stock market delivered a striking vote of skepticism on President Trump’s description, delivered via Twitter, of the agreement reached between the U.S. President and China’s President Xi Jinping. It’s proving to be very difficult to nail down exactly what kind of deal, if any, was struck in Buenos Aires. At the least, it seems right now, that the U.S. President’s Twitter account of an agreement by China to buy lots of U.S. products–farm and energy products mainly–was premature. It now seems likely that there is an agreement in principle for Chinese purchases but that the details remain to be worked out. In addition, the President’s Twitter description that China had agreed to cut tariffs on U.S. auto exports to China to 0% has yet to be confirmed by China and is now being described by White House sources as an agreement to negotiate those tariffs. It’s no wonder, then, the stocks such as Caterpillar (CAT) and Boeing (BA) and Deere (DE), all big exporters that soared in yesterday’s optimism were down heavily today. These three stocks fell 6.93%, 4.85% and 5.85%, respectively.
Second and third, though, the worries over whether the trade truce is everything that was touted yesterday–it isn’t–has focused worries on two more fundamental worries about 2019.
So second, we have worry that 2019 is going to see a big drop in the rate of corporate earnings growth.
And third, we have worries that various indicators, most recently the inversion in the Treasury yield curve, are signaling an economic recession in 2019.
It’s really important to recognize that these are two separate issues. With wildly different odds that the worries will bear fruit. And that the connection between the two–a drop in earnings growth and a recession–are by no means straight forward.
To start with the worries about a big drop in corporate earnings growth in 2019: I think this is virtually certain absent some currently unanticipated surge in domestic or global economic growth. Right now the consensus among Wall Street analysts as calculated by Yardeni Research is that earnings per share of the companies in the Standard & Poor’s 500 index will grow y 24.0% in 2018. That would be a substantial increase from 11.2% growth in 2017.
But the consensus sees earnings growth dropping to 8.5% in 2019 and only recovering to 10.3% year over year growth in 2020.
All things being equal–and of course, they’re not–I think the 2019 drop in earnings growth from the extraordinary 2018 growth rate is just about guaranteed. Among the things not being equal, we’ve got the global economic slowdown caused by the Trump administration’s tariff policy and the trade war (truce or not) with China. We’ve got slowing economic growth–for domestic reasons–in the EuroZone and in China. We got slowdowns caused by the strong U.S. dollar in developing markets. We’re got slowing growth in key fast growth markets ranging from smartphones to chips. And we don’t have the big one-time boost to earnings resulting from the December 2017 cuts in the corporate tax rate. Rates haven’t gone back up–but they haven’t dipped further so companies won’t be reporting big additions to their bottom lines in 2019 as they did in 2018 from plunging tax rates. This tax cut was supposed to lead to a huge surge in capital investment that would drive economic growth higher but so far the numbers don’t show the projected increase in capital investment. Wall Street expects the drop in earnings growth to hit in the fourth quarter when the earnings growth rate for the S&P 500 stocks is projected to go to 15% from 27.6% in the third quarter. Now 15% growth would still impressive growth in many markets but it’s only a slowdown in the context of 2018 growth rates.
Worries about an economic recession in 2019 have been building for a while. The housing market, for example, has been turning in worrying weak numbers, for example. But those worries gained a new credibility in recent days with the inversion of part of the Treasury yield curve. In a “normal” yield curve bonds with longer to go until maturity pay higher yields than near-term instruments. Only makes sense right since any investor buying a longer maturity bond is locking up money for longer and therefore taking on more risk. The yield curve is said to be “inverted” when shorter maturities pay more than longer maturities. That’s seen as a sign that markets expect longer term interest rates to drop because a future recession has led the Federal Reserve to cut interest rates.
On Monday a section of the Treasury yield curve inverted–for the first time since 2007–when in the middle of Treasury maturities the yield on the 5-year Treasury note fell below the yield on the 3-year note. An inversion also occurred in the yield between the two- and five-year notes with the yield. The 2-year and 5-year notes finished the day both yielding 2.79%.
This set off a huge wave of speculative fear that an inversion of the 2-year and 10-year notes was next. These two maturities are seen as benchmarks for the Federal Reserve’s policy and for the direction of long-term interest rates, respectively. At just before 1 p.m. New York time the difference between the 2-year and the 10-year notes narrowed to just 10.4 basis points. That’s the smallest difference in more than 11 years. The difference widened by the end of the day to 12 basis points. (It takes 100 basis points to make up a percentage point.)
The conclusion at this point in the day was that the bond market was predicting a recession in 2019. Which put the recession much closer than had been predicted by many economists who were looking at 2020 recently.
That accelerated schedule for a possible recession hit financial stocks really really hard. The sector, which takes turns trading position with the technology sector as the biggest in the S&P 500, plunged today with the Financial Select Select SPDR ETF (XLF) dropping 4.35%. That was a bigger plunge than for the Technology Select Sector SPDR ETF (XLK), down 3.79% on the day, or the Energy Select Sector SPDR ETF (XLE) down 2.87%. (The S&P 500 itself was down “just” 3.24% on the day.) And that drop in the financials meant that the market as a whole had lost both of its key leadership sectors. The drop in the Financials ETF took the price down to $25.96, that’s below the $26.50 level that many analysts have cited recently as key support for the sector.
It’s important to remember, however, that while recessions are preceded by inversions of the yield curve, not all inversions accurately predict recessions or their timing. It is possible the bond market has got it wrong. (Frankly that’s my read–that the financial markets over-reacted to the inversion in the yield curve in a kind of snit that expressed their dissatisfaction with the trade uncertainly flowing out of the White House.)
Last we all looked (the third quarter of 2018) the year over year growth rate in the U.S. economy was a healthy 3.5%. That’s down from 4.2% in the second quarter, but it still leaves the economy with lots of room before it falls into negative territory.
And last week’s speech by Federal Reserve chair Jerome Powell signaled that the Federal Reserve isn’t locked into a program of interest rate increases in 2019 if the danger is throwing the economy into recession. The Fed is still likely to raise interest rates when it meets on December 19–the CME FedWatch tool puts the odds of an interest rate increase at that meeting at 80%–but the odds for additional interest rate increases at the Fed’s March or May meeting is only around 40%, according to prices in the Fed Funds Futures market.
We get the next estimate on third quarter GDP growth on December 21 and I doubt that it will show much of any change from the second estimate.
The big event in the near term is the November jobs report due this Friday. (I posted on the possible effects of that report earlier today.) Following that, the market will be looking to the Fed’s December 19 meeting both for a move one interest rate and for language that hints at the Fed’s rate increase schedule for 2019.
