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Source: Strategas, Avalon Investment & Advisory as of November 7, 2019

Chart of the Week: Why is the S&P 500 hitting new highs when 3Q earnings are negative year-over-year and global economic growth remains challenged? Global PMIs and sentiment seem to have at least stabilized and perhaps bottomed (see chart). Since the end of 3Q, markets have been signaling that better economic and earnings data are coming. 10-year Treasury yields moved higher while the yield curve has steepened, and corporate bond spreads have narrowed. In addition, more procyclical parts of the market like industrials, financials, emerging markets and small caps have outperformed while staples and utilities have lagged. Value stocks have also begun to outperform after a long stretch of underperformance. The markets are not always correct forecasters, but Avalon believes there is more upside if the recessionary and trade risks priced into the market continue to recede.

  WEEK IN PREVIEW

• Geopolitical: Markets will monitor the progress of the phase one trade negotiations between the U.S. and China. The agreement could be signed by Presidents Trump and Xi in mid-November through December. Movement of the Yuan/U.S. dollar and tweets will be closely watched for any signs of deterioration or improvement in sentiment around completion of this phase and future phases. U.S. public impeachment hearings begin. Spain held a general election on Sunday with PM Sanchez’s Socialist party unable to get a working majority.
• U.S.: October consumer inflation year-over-year (Y/Y) is expected to hold steady at 1.7%. Retail sales for October should accelerate with the headline reading moving to 0.2% month-over-month (M/M) from -0.3%. Fed Chairman Powell appears before Congress, but not much new information is likely to be revealed. At least 13 speeches from other Fed members are also on tap. The Atlanta and NY Fed currently estimate 4Q GDP growth at 1.01% and 0.73%, respectively, but these estimates are likely too low due to a lack of 4Q data so far.
• 3Q S&P 500 Earnings: With 89% of companies having reported, 75% and 60% have exceeded earnings and sales estimates respectively. Earnings improved to -2.4% Y/Y, while sales rose to 3.2% with multiple sectors contributing. Only 15 companies are scheduled to release earnings.
• Europe: The German economy may have contracted slightly in 3Q, marking a technical recession, though a deep downturn looks unlikely. November German ZEW sentiment surveys expected to show improvement. U.K. GDP growth rebounded to 0.3% quarter-over-quarter in 3Q but Y/Y slowed to 1.0%. Brexit scenarios hinge on the U.K. general election scheduled for December 12 after the E.U. granted a Brexit deadline delay until January 31.
• Asia: Japan September core machine orders fell at -2.9% M/M but the Y/Y is still positive at 5.1%. Japan 3Q GDP expected at 0.9% annualized. October China industrial production probably grew at 5.4% Y/Y and retail sales at 7.8%. Alibaba Group held Singles’ Day, the world’s biggest shopping event, and sales exceeded last year’s record.
• Central Banks: The central banks of New Zealand, the Philippines, Mexico and Egypt meet with New Zealand, Mexico and Egypt expected to cut rates. Avalon expects the global central banks will continue to ease policy to offset the trade drag on growth.

  WEEK IN REVIEW

• The S&P 500 gained +0.9% and set another all-time high as earnings season continued to provide a positive surprise along with support from trade news. Financials (+2.4%), energy (+2.0%) and materials (+2.0%) outperformed the S&P 500, while utilities (-3.7%), real estate (-3.7%) and consumer staples (-0.5%) were the biggest laggards. WTI (+1.9%) and Brent (+1.3%) crude oil prices were higher for the week, lifting the energy sector (+2.0%) but MLPs could not keep up (-3.4%). Small cap stocks underperformed with the Russell 2000 up +0.6%. The 10-year U.S. Treasury yield moved higher to 1.94%. High yield credit spreads narrowed, reflecting increased risk appetite.
• The U.S. dollar was stronger against developed currencies and emerging market currencies. Developed international stocks as measured by MSCI EAFE underperformed the S&P 500 returns in U.S. dollar terms (+0.5%) but outperformed on a hedged-currency basis (+1.6%). Emerging market stocks outperformed the S&P 500 with the non-hedged return of +1.5% for MSCI EM.
• The 10-2 yield curve steepened to +26 basis points. Another curve measure of three-month yield six quarters forward – three-month yield also widened to +21 basis points. The yield curve has historically provided an accurate forecast of future recessions when the difference in these measures turns negative, also known as inversion. Yield curves are one of the major indicators that we monitor to judge recession risk, but these inversions typically happen more than a year in advance of an economic recession. In addition, stocks have historically had significant advances post-inversion. The three-month yield six quarters forward yield is now reflecting that the market expects as much as one net hike in short-term rates over the next year and a half. Our view remains that the Federal Reserve is on hold for the remainder of 2019 and odds of a recession over the next twelve months remain below 50%. Avalon continues to monitor the data closely. Please see our Avalon Perspectives publication, The Yield Curve and Equity Returns, from April 26, 2018, for more details.

Phan Phan Duong, Senior Analyst

Henry J. Lartigue, CFA, Managing Partner

Samuel E. Rines, Chief Economist

Bill Stone, CFA, CMT, Chief Investment Officer

This report is furnished for the use of Avalon Investment & Advisory and its clients and does not constitute the provision of investment or economic advice to any person, nor the recommendation of any security. Persons reading this report should consult with their investment advisor regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report. Statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness, or completeness by Avalon Investment & Advisory. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Avalon Investment & Advisory does not provide legal, tax, or accounting advice. ©2019 Avalon Investment & Advisory. All rights reserved.

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