A Stock Market Correction? What About Corporate Earnings?

The big question now is whether the stock market will correct in January -- and, if so, to what extent.  Those looking for a correction see anywhere between a 3-10% decline in the S&P 500.  All, however, view a pullback as a buying opportunity -- which argues for only a modest decline if this is generally believed.  While corporate earnings expectations do not appear particularly troubling, a high Price/Earnings (P/E) Ratio is a concern.  Stocks may have outrun fundamentals.  A trigger for a correction could be soft key macro-economic data in early January.  At this point, evidence points to a sub-50 December Mfg ISM and a smaller increase in December Payrolls than November's +266k.

Corporate Earnings
The Q419 earnings season, which will begin in a few weeks, should not precipitate a correction.  The consensus estimate has moved up.  Although it is still negative, it is less so than the y/y decline seen in Q319.  Macro evidence supports expectations of an improvement in earnings from Q319.  Further ahead, expectations are for strong earnings growth in 2020. 

According to Insight, consensus expectations for Q419 Corporate Earnings are now -1.4% (y/y), better than the -2.3% in Q319 and the Q419 consensus estimate of -2.5% made at the end of Q319.   FactSet says that while downward revisions for some companies have been relatively large, the percentage of companies making downward revisions was smaller than normal.  

The macro evidence supports expectations of better corporate earnings in Q419 than in Q319.  Real GDP Growth has sped up on a y/y basis, using the Atlanta Fed model's 2.3% estimate for Q419.  Oil prices have flattened out after sinking by double-digit rates in the prior 3 quarters.  Profit margins may have improved, as wage inflation slowed while price inflation was steady.  Oil profits should benefit from an easing in price deflation.  And, earnings from abroad should be better, as the slowdown in non-US economic growth stabilized as has dollar weakness. 

                                                                                                                                         Markit
                                                                                                                                          Eurozone              Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q117            1.9                +65.3                  2.3                              2.7          2.2                55.6
Q217            2.1                +13.1                  3.1                              2.5          1.8                56.8
Q317            2.3                 +6.0                 -1.9                              2.5           1.7               57.4
Q417            2.5               +12.7                 -4.1                              2.5           1.7               59.7

Q118            2.6               +21.5                 -6.6                              2.7           1.9               59.1
Q218            2.9               +41.0                 -1.8                              2.7           2.2               55.9
Q318            3.0               +45.4                 +5.1                             2.8           2.2               54.3
Q418            3.0                 +6.7                 +6.5                             3.3           2.2               51.7

Q119            3.2                -12.8                 +7.9                             3.2           2.1               51.9 
Q219            2.7                -12.2                 +5.9                             3.1           2.1               47.8    
Q319            2.1                -19.2                 +3.6                             3.2           2.3               46.4
Q419            2.4                  -3.8                 +1.7                             3.1           2.3               46.2

FactSet says that consensus now looks for a 9.6% y/y increase in corporate earnings in 2020, which would be above the 9.1% 10-year average.  However, the Price/Earnings Ratio still would be high, with the S&P 500 expected to rise to 3430.  The forward 12-month P/E ratio would be 18.0, which exceeds the 5-year average of 16.6 and the 10-year average of 14.9.   A corrective decline in the S&P 500  to 3000 (-7.4% from Friday's 3240 level) would put this P/E ratio at 15.7.   This level would likely be viewed low enough to allow for a renewed rally.

P.S.    I just published a book that analyzes the theology of the Old Testament. The book's title is "Finding Judaism in the Torah" and is on amazon.com. While it does not involve economics or the markets that I write about on my blog, it uses the same objective analytical approach I apply to understanding the import of economic data.

Two Issues Facing the Markets in 2020

The two biggest issues facing the markets in 2020 will be /1/ whether US/global economic growth picks up enough to generate higher inflation and /2/ whether the left-wing Democratic presidential contenders will win the nomination and election.   An affirmative outcome to either would be a major negative for the stock market.  At this point, however, neither appears relevant for the next couple of months. 

US economic growth in Q419 is slightly above trend, according to the Atlanta Fed model's latest Real GDP Growth  estimate of 2.1%.  Longer-run trend is viewed to be between 1.8-2.0%.  The decline in the Unemployment Rate over October-November supports this above-trend depiction of Q419 GDP Growth.  However, the Unemployment Claims data have worsened so far in December.  Their higher prints may have resulted from seasonal adjustment distortions in this holiday period.  Or, a pickup in layoffs might have been a lagged response to the slower growth seen in the prior two quarters.  Then again,  they may, in fact, stem from an actual slowing in economic activity.  Boeing's stoppage of Max 737 plane production beginning January could be a significant drag on Q120 Real GDP Growth.  Anticipatory layoffs in supplier industries may have contributed to the increase in the Claims data.

While there has been some modest improvement in European and Chinese business survey data, they are still at low levels.  Germany seems to be particularly soft.  German manufacturers may be particularly hurt by softer demand from China.  Also, it is conceivable they have lost a competitive edge to the US and other European countries because of higher electricity prices that resulted from its shift to renewable energy supplies.  The German Markit PMI is well below those of other European countries.   The loss of a competitive edge within the euro area cannot be offset by a weaker currency.

Meanwhile, US inflation remains low.  The Core PCE Deflator slowed to 1.6% y/y in December.  Possibly even more troubling to the Fed is the University of Michigan 5-Year Inflation Expectations, which fell to a new low of 2.2% in December.

Regarding the presidential race, the left-wing candidates -- Warren and Sanders -- are trailing the more moderate candidates.  The first major test will be on Super Tuesday, March 3, when 14 states (representing 1/3 of the population) hold primaries.  Until then, the presidential election will be more in the background for the markets. 

A Weaker Dollar

Last week saw the resolution of 3 major issues that had weighed on the stock market -- US/China Phase 1 trade agreement, likelihood of near-term Brexit after Boris Johnson's election victory, and clarity on the Fed's expectations for monetary policy in 2020.   All three resolutions are positive for the stock market.  And, a Christmas rally that persists into January seems likely.  But, they all have one implication that is negative for Treasuries (in terms of price) -- a weaker dollar.

While analysts may debate whether the US/China trade resolution is meaningful or not, it does eliminate for now the risk of a worsening trade war.  So, there should be an unwinding of a "flight to safety" demand for dollars.  Also, any expected widening of the US trade deficit as a result of the reduction in tariffs will put downward pressure on the dollar.

The euro and pound already have begun to strengthen as a result of Johnson's victory.  The reduced likelihood of an abrupt dropping out of the UK from the Euro Area is a positive for the business outlook there, which should help lift these currencies versus the dollar.

The Fed's expectation are for steady monetary policy in 2020 despite an expectations for above-trend GDP Growth  and higher inflation.  This inflationary policy stance should hurt the dollar. 

The Fed's policy stance and the weaker dollar have inflationary implications.  So, they are negatives for the long-end of the Treasury curve and could result in a further steepening in the  yield curve.  

While the Impeachment Inquiry is a non-event for the markets, as it is expected to be defeated in the Senate, the decline of Elizabeth Warren and Bernie Sanders in the polls already may have contributed to the steepening of the medium-term Treasury yield curve.  Their disruptive policy ideas have become less likely to be put into effect during the next 5 years.

With longer-term Treasury yields already back up, and with the risk that they will rise further next year, any strength in this week's housing-related data releases will likely be ignored as temporary.  November Industrial Production also should be largely discounted as one-off -- it should jump as motor vehicle output bounces back from the GM strike.  European Markit PMIs need to rise by more than the modest increases seen by consensus to be significant.

More important for the outlook will be whether forward-looking manufacturing-related data improve, due a week later.  In particular, increases in Core Durable Goods Orders (Non-defense Capital Goods Excluding Civilian Aircraft) would show that the drag from the trade war is dissipating and would move in a direction that eliminates one of the negative risks -- weak capital spending -- in the outlook seen by the Fed.  Higher oil prices also should work not only to lift inflation but to spur increased oil drilling -- which feeds into Business Investment in GDP.

Long-Standing Hurdles About to be Resolved?

Some of the long-standing hurdles for the markets --Brexit and US/China negotiations -- potentially will be resolved this week.   Stock-market friendly outcomes are possible.  The question is whether the pickup in US economic growth now occurring will override the impact of negative outcomes.  My guess is that it will, so any market pullback on the news could be short-lived and a buying opportunity.

UK Elections and Brexit
The outcome of Thursday's UK elections will determine whether an orderly Brexit will proceed.  The latter at this point would seem to be likely, since polls show Boris Johnson in the lead.  In contrast, if the election outcome suggests otherwise, any negative impact on the UK or Euro area economies will probably be met eventually by BoE and ECB policy easing.  So, the market's knee-jerk negative reaction could reverse.

US/China Negotiations
This week should see one of three outcomes -- /1/ a Phase 1 agreement, /2/ Postponement of the December 15 tariffs and continuation of talks, or /3/ a breakdown with both sides saying further talks will await the outcome of next year's Presidential election.  The December 15 tariffs would go into effect.

The market reactions would be:

First Outcome --  Stocks would jump and Treasuries sell off sharply.

Second Outcome -- Stocks might sell off on the announcement, but then quickly resume the rally.

Third Outcome -- Stocks would sell off sharply and Treasuries rally moderately.

The Treasury market move will be partly a reaction to the stock market and partly to the implications for inflation.  Regarding the latter, note that a paring of US tariffs as part of a Phase 1 agreement would likely weaken the dollar.  This would lift import prices and possibly more than offset the direct decline in the prices of tariff-targeted goods.  Similarly, the imposition of new tariffs on December 15 should boost the dollar, which will hold down import prices.

The stock market should interpret an outcome in terms of the impact on US and global economic growth.  The third outcome would be viewed as the most likely to drag down growth.  Even in this case, the recession risks may very well be downplayed by Street economists, given the improving momentum in the US economy and the potential of a Fed easing if economic activity slows sharply.  So, a knee-jerk drop in stocks will be probably be short-lived.

FOMC Meeting
This meeting will probably be a non-event.  The FOMC Statement should underscore the Fed's desire to keep policy steady for the foreseeable future.  At the same time, either the Statement or Powell's post-meeting press conference will likely continue to suggest policy is now pro-growth as inflation remains below target and that officials remain focused on "global developments."  Note that the outcomes of the UK elections and most likely US/China negotiations will not be known at the time of the meeting.

Key US Economic Data
The November Retail Sales and CPI Reports are expected to show a solid consumer and benign inflation.  Consensus looks for +0.4% m/m Ex Auto Retail Sales and +0.2% Core CPI  (with a steady 2.3% y/y).  While Thanksgiving was late this year, there was a lot of retail discounting ahead of the holiday, which might have resulted in earlier-than-usual shopping.  This could "fool" seasonal adjustment.  So, the risk is for the prints to come in lower than consensus for the Core CPI and higher than consensus for Ex Auto Retail Sales.  

The Atlanta Fed model's estimate of Q419 Real GDP Growth is now up to 2.0%.  This is still likely too low relative to the Total Hours Worked data.  An upward revision on strong prints this week would not be a surprise when the model's estimate is updated on Friday. 

November Employment Report Argues for Above-Trend Growth With Little Inflation

The November Employment Report provides more evidence that economic growth is speeding up through Q419.  It suggests GDP Growth is already above trend.  Payrolls surged and the Unemployment Rate moved down.  Nevertheless, wage inflation still looks to be in check.  So, the Fed should remain on the sidelines for awhile.  This situation is a big positive for stocks and a moderate negative for longer-term Treasuries.

The +266k m/m surge in Nonfarm Payrolls, with upward revisions to October (to +156k  from +128k) and September (to +193k from +180k), puts the 3-month average at +205k -- the first time over 200k since January 2019.  (The 3-month average eliminates the boost by the 44k net returning strikers in November, as the latter is offset by the corresponding drag in October.)  The gains were mostly in services, particularly in health care (with a jump in ambulatory personnel).  Manufacturing jobs were up even excluding the 46k returning GM strikers.  Ex returning strikers, these jobs rose 8k.  Construction jobs rose only 1k, but this was after an upward-revised 14k in October (was 10k) -- they still show only a modest uptrend in this sector.  Retail jobs edged up 2k, with a 22k jump in general merchandise more than offsetting an 18k drop in apparel stores. 

The dip in the Unemployment Rate to 3.5% from 3.6% (rounding down after rounding up in October) argues for above-trend GDP Growth in Q419.  The October-November average is 3.5% versus 3.6% in Q319.  The Labor Force Participation Rate dipped to 63.2% from 63.3%, but remains in the higher range seen since August.

Total Hours Worked also argue for above-trend GDP Growth in Q419.  Their November level is 2.3% (annualized) above the Q319 average.  They suggest that the Atlanta Fed model's estimate of Q419 Real GDP Growth will be revised up from 1.5%.   The consensus of Street Economists also will likely be revised up.

Wage inflation remains subdued.  Average Hourly Earnings rose 0.2% m/m after an upward-revised 0.4% in October (was 0.2%).  The y/y slipped to 3.1% from an upward-revised 3.2% (was 3.0%) in October.

Caution Up, But So Is Economy

Two of the three areas of concern for the market -- US/China negotiations and the impeachment inquiry -- risk exerting downward pressure on the stock market in the next couple of weeks.  US legislation supporting the Hong Kong protestors could be a stumbling block for a resolution ahead of the December 15 trigger of new US tariffs.  And, the House looks to be heading for a vote on impeachment at some point this month.  Meanwhile, US and global economic data are turning stronger, which is a positive for stocks.  This positive development may not be enough to offset the negative effects of these two areas of concern near term.

Ironically, the stronger economic data conceivably could tempt the US and China to dig in further to their positions, making a resolution more difficult to achieve.  The official Chinese PMI moved above 50 in November.  And, the risk is for the Mfg ISM to increase for the 2nd month in a row in November.  Consensus looks for it to rise to 49.2 from 48.3 in October.  The risk is for an even bigger increase, given that the figure measures the number of companies seeing steady to better performance regardless of the magnitude of of the improvement.  Most other surveys rose in November, including the Markit US Mfg PMI, Phil Fed Mfg Index and the Chicago PMI.

An increase in the November Mfg ISM (and a consensus-like increase in October Construction Spending) on Monday should boost the Atlanta Fed model's estimate of Q419 Real GDP Growth.  Last week's data already boosted it to 1.7% from 0.4%, bringing it better in line with the Total Hours Worked data in the October Employment Report.  GDP Growth of around 2.0% is around trend and should not cause a bit hit to Treasuries.  Longer-term yields should rise a bit but not so much as to undermine the stock market uptrend.   Much stronger economic growth that brings a Fed tightening back in the picture is what would derail the stock market uptrend.

Besides the US Mfg ISM, the other key report this week will be the November Employment Report.  Payrolls will be boosted by about 44k net returning strikers (GM workers).  Workers laid off in supplier companies because of the strike should return, as well.  Consensus expects +180k m/m for Total Payrolls, but the risk would seem to be on the higher side.  The Claims data argue for a stronger print than the +128k in October.

Although the returning strikers will not impact the Unemployment Rate, the underlying job gains are strong enough to suggest a further decline.  Consensus looks for a steady 3.6%, however.  Calendar considerations and possibly the inclusion of high-paid auto workers point to a 0.3% m/m print for Average Hourly Earnings, in line with consensus.  The y/y would be 3.0-3.1%, versus 3.0% in October.