Highlights

• The provisional trade deal announced on Friday reduces some near-term policy risk, but trade issues remain a wildcard for financial markets.

• Corporate earnings expectations have come down for the third quarter, but we think they remain too high for the coming quarters.

• Improvement in manufacturing is key to the outlook for stocks. We have reasons for hope on that front.

After declining for three weeks, equity prices advanced last week, helped largely by Friday’s sharp rally following the announcement of a “Phase One” U.S/China trade deal.¹ Sentiment was also helped by some improving economic data. For the week, cyclical sectors such as materials, industrials and technology led the way, while more defensive areas of the market lagged.¹ In other markets, Treasury yields rose notably as part of the broader risk-on trend.¹

Weekly Top Themes

1. The “Phase One” trade agreement is good news for markets, but trade policy remains a significant risk. The agreement is essentially a near-term truce. In exchange for the U.S. delaying new tariffs, China will increase agricultural imports and make modest concessions around intellectual property and currency protections. This development should reduce some near-term trade policy risks, but we don’t expect any major agreements before the U.S. 2020 elections.

2. Brexit progress also reduces near-term policy risk. This issue remains dicey, but ongoing talks between the UK and European Union helped propel the broader risk-on trade last week.

3. U.S. consumer spending remains resilient. The University of Michigan’s Index of Consumer Sentiment rose unexpectedly in September, suggesting consumption levels are remaining strong even as other areas of the economy struggle.²

4. The Federal Reserve may cut rates again this month, but the minutes from the September meeting suggest the bar is rising for future cuts.

5. Corporate earnings are likely to be weak for the third quarter. Consensus expectations anticipate a 3% drop in bottom-line results.³ The good news is that because negative results are already expected, there may be room for positive surprises. But any surprises are likely to be limited, as only the health care, utilities and technology sectors have shown upward revisions in expectations this past quarter.³

6. Impeachment proceedings raise risk premiums for stocks, but have not yet affected our long-term outlook. We think this issue warrants careful monitoring to see if and how it will affect financial markets, but for now we think economic and corporate fundamentals remain more important to the long-term direction.

7. We are starting to see increased opportunities in non-U.S. stocks. U.S. markets continue to outperform most other areas of the world, but we are seeing signs of life in other areas, particularly emerging markets.

If Economic Growth Improves, Stock Prices Should Benefit

The global political backdrop has worsened in recent months, with rising tensions in the Middle East, uncertain U.S/China trade, Brexit and U.S. political infighting adding to economic and market uncertainty. The global economy runs the risk that the weakness in manufacturing, trade and capital expenditures could spill over to the still-strong labor market and consumer sector. If that should happen, the odds of a recession would grow.

The good news, though, is that so far there are only limited signs that this is happening. In fact, broader economic growth expectations may be too low. The Chinese economy appears to be getting back on track, with improvements in manufacturing and China’s rising demand for oil. And in the United States, recent purchasing managers’ index readings show strengthening manufacturing activity.⁴

In all, the economic risks appear fairly balanced. During most economic cycles, the expansion phase ends when monetary conditions tighten to the point that credit becomes unavailable. Given that the U.S. and the rest of the world are now in a monetary easing mode, that tightening doesn’t seem likely any time soon. The main economic risks seem to be coming from the political sphere, which is tough to gauge.

The earnings backdrop will be critical to the future direction of equity prices. Expectations for third quarter earnings results have already fallen to the point that we don’t expect negative surprises. But, in our opinion, expectations for the fourth quarter and 2020 remain too high, which could subject the markets to a negative shock should results fail to meet expectations. On balance, we do not expect a sharp recovery in global economic growth, but easing in U.S./ China trade tensions could boost manufacturing. This would be a significant catalyst for improving equity prices.

Robert C. Doll is chief equity strategist and senior portfolio manager at Nuveen.

 

¹ Source: FactSet, Morningstar Direct and Bloomberg
² Source: University of Michigan
³ Source: Raymond James Research
⁴ Source: Markit Economics