We are in the middle of corporate earnings season following the end of the third quarter. Earnings reports give great insight into economic activity as companies across all industries report results and adjust future expectations. With 33% of S&P 500 companies having reported as of October 24th, earnings have fallen -1.2% from the third quarter of last year. Strength is seen in Consumer Services, Consumer Discretionary, Consumer Staples, Health Care, Real Estate, and Utilities sectors. Weakness is within Materials, Information Tech (specifically equipment), Energy, Industrials, and Financials. Do you notice a pattern? Consumer and service focused sectors are so far reporting higher earnings in the third quarter. Manufacturing and cyclical sectors are not. The technology sector is particularly instructive. Info tech as a sector is further divided into industries. The only tech industry showing positive earnings growth so far this quarter is software. Industries focused on equipment and semiconductor manufacturing are so far exhibiting an earnings decline for the quarter, as compared to last year.

 

While earnings are backwards looking, stock price performance is forward looking. We manage three large company, equity style strategies, and understanding the source of each portfolio's positive or negative performance against the benchmark on a daily basis is part of the management process.

The portfolios have been positioned for defensive growth and away from more tariff sensitive exposures throughout 2019. This has proved successful. However, we noticed something beginning in August. The cyclical exposures we have not emphasized so far this year began to outperform. Specifically, banks within the Financial sector, and equipment within the Technology sector. Signs of trend reversals show themselves frequently in financial markets, but they don't always follow through into something a portfolio manager can, or should, implement to add value. We liken picking stocks for our strategies to fielding a sports team. There are companies we like in all sectors and industries, but you have to know when to put the right ones on the field. You don't put your best pass blockers in the game to help power a running back into the end zone during a goal line stand. There's another bit of wisdom. Listen to what the market is telling you, but confirm with data. Know when to adjust. Skepticism is good. Stubbornness is not.

 

Let's revisit a few pieces of data. Here are the global PMIs over the past two years for manufacturing and services. The U.S. PMIs mirror the global. Both PMIs have been in a downtrend since the beginning of 2018. But have we seen the worst? Is that slight turn the beginning of a sustained improvement?

 

The last Fed rate increase was December of 2018. The first cut was July of 2019, followed by September, and very likely another next week in October. Global central banks have generally been accommodative in other countries since the summer. The global economic slowing has meant longer term interest rates also fell, leading to lower home mortgage rates. This re-invigorated housing and mortgage refinancing... some in the form of cash-out refinancing. However, the consumer has not really been the issue. Weakness has come from the business side through trade uncertainty, and tough earnings growth comparisons against last year's tax-rate cut fueled earnings climb. The confidence chart below tells the story perfectly. CEO confidence is weak. Consumer confidence is steady.

Business confidence is worrisome. It reflects the lower manufacturing PMIs, trade and geopolitical uncertainty. Earnings reports from the likes of Texas Instruments and Caterpillar have cited slower global demand and tariff issues. We've recently seen some better headlines with respect to Chinese trade negotiations, and suggestions from Commerce Secretary Wilbur Ross that tariffs on European auto imports are not the favored path. However, investors have been burned before by acting on expectations for improving trade talks.

 

Here is one more data item. The bond market can communicate expectations for future growth. Remember not too long ago when you couldn't turn on financial news without hearing of an inverted yield curve and what it may or may not mean about recession odds? The red line in the chart below represents the difference between the 10 year U.S. Treasury yield and the 2 year U.S. Treasury yield. That spread contains a lot of information about future expectations for growth and inflation. It did briefly reach zero and invert ever so slightly. Now the yield curve has regained a small amount of steepness. Certainly not much, but this is another maybe in the trend change direction.

   

And then finally, the U.S. Federal Reserve meets October 30th to discuss the economic outlook and most likely lower the Fed Funds target rate by another 0.25%.  Markets are expecting this cut with a high degree of certainty.  Importantly, the Fed will give its future outlook for further rate increases or decreases, and markets will respond accordingly.  It's a pretty safe bet to expect the phrase "data dependent" in the statement.  Aren't we all? 

 

So, investors have a great deal to ponder as we enter the final quarter of 2019.  Will these small indications of growth improvement mean GDP estimates need to be revised higher in 2020?  Has the combination of a strong consumer and monetary stimulus begun to stabilize the weaker economic trends?  Will trade talks continue to positively progress?  Should investors consider adding more cyclicality to their stock and bond portfolios?  We're not yet convinced, but we are paying attention.