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Markets were relatively subdued following last week’s selloff in oil and the worst one-day drop since September the week before. Even so, stocks managed to find the strength to power higher to close out the week, pushing again toward all-time highs. Driving conversations this week were: President Trump’s decision to withdraw from the Paris climate agreement and Friday’s monthly nonfarms payroll report (more below). Some lagging earnings reports also drifted through the headlines.
Looking ahead, with earnings season all but complete, investors turn their focus to the Federal Reserve, which will meet in the coming weeks to decide whether to raise interest rates. While the Fed is largely expected to move on rates at this month’s policy meeting, we will be keying more so on Fed Chair Janet Yellen’s commentary following the FOMC’s decision to get a better idea of the outlook for the economy moving forward.
For this week, Treasury yields trended sideways before a rush to safety put bonds in demand on Friday following a disappointing jobs report for May. Gold also pushed higher on the report as investors attempted to decipher an uncertain economic outlook. The dollar weakened against the euro throughout the week and oil continued its decline, stemming from last week’s OPEC Vienna summit.
First-quarter earnings are nearly complete and have been relatively positive versus expectations, with 73.3% of companies reporting a positive EPS surprise. In the portfolio, Hewlett Packard Enterprises (HPE) reported earnings this week.
HPE reported a top-line beat after Thursday’s close while matching consensus on the bottom line. Total revenues of $9.9 billion were surprisingly not as pressured as expected and beat consensus expectations of roughly $9.6 billion. Adjusted EPS of $0.35, on the other hand, was in line with prior guidance of $0.33 to $0.37 and equaled consensus. Digging deeper, revenues from continuing operations — which include Enterprise Group, Financial Services and Software (to be spun off later this year to merge with Micro Focus) — came in at $7.4 billion, down 13% year over year due to pressures in the key EG group as well as foreign currency and divestitures headwinds. In total, revenues from continuing operations were lower by 5% year over year when excluding these headwinds.
As for the broader macro, despite the shortened holiday week, we received several key economic indicators that will help frame the outlook moving forward.
On Tuesday, the Commerce Department reported that both personal income and spending rose 0.4% in April, in line with expectations. The rise in income came primarily because of increased private wages and salaries, while the 0.4% rise in personal spending marked the largest monthly rise since December. In addition to the April rise, spending for March was revised up to 0.3% (from a flat reading previously reported).
Importantly, the PCE price index increased 0.2% month over month after falling 0.2% in March. Core PCE (which takes out food and energy to reduce month-to-month volatility) also rose 0.2% in April (following a 0.1% decline in March), beating expectations for a 0.1% rise. More importantly, on a year-over-year basis, the core PCE price index is up 1.5% (down from a 1.6% year-over-year rise in March). This measure is closely followed given that it represents the Fed’s preferred measure of inflation, which comprises one portion of the Fed’s dual mandate when determining the outlook for rates (the other being maximizing employment).
Recall that the Fed ideally targets a 2% rate of inflation — the core PCE has generally run below this target in recent years — and despite some strength in prior months, investors must balance rate hike expectations this year with the declines in core PCE in March and April. Even though the month-over-month beat in core PCE is a welcome surprise, the year-over-year numbers are generally followed more closely. We will be watching the Fed policy meeting later this month to determine how recent data have affected the committee’s outlook for rates moving forward.
On Tuesday night, the Chinese National Bureau of Statistics reported that the Chinese manufacturing Purchasing Managers Index (PMI) was 51.2 in May, beating expectations of 51.0 but flat month over month. On a year-over-year basis, the index is up 2.2%. Recall that anything over 50 represents expansion while anything below 50 indicates a contraction. The increase can be largely attributed to China’s steel sector (steel PMI rose to 54.8 from 49.1 in April. according to the China Federation of Logistics and Purchasing), which saw its fastest rate of growth in a year on the back of healthy infrastructure investments.
Importantly, the May PMI showed the 10th consecutive month where activity levels improved from a month earlier, indicating that conditions across China’s all-important industrial sector may be gradually improving after a prolonged period of weakness in 2015 and early 2016. Recall that markets sold off during this period as investors had a tough time grappling with potential headwinds facing the global economy. Although China was still growing at a fast clip, the deceleration from the government’s initial expectations served as a wake-up call for investors at the time.
While these fears appear to have abated for now (as evidenced by the strong economic performance of late in the country), questions still remain: According to IHS Markit, its PMI on China (released later in the week) came in at 49.6, below the 50.3 level reported in April and worse than expectations for a smaller decline to 50.1. Markit conducts an independent survey different from the official PMI, raising doubts regarding the trustworthiness of the Chinese government and the veracity of the country’s internal data.
Also on Tuesday night, the Japanese Ministry of Economy, Trade and Industry reported that industrial production rose to 103.8 (the highest level since 2008), a 4% increase from April and a 5.7% increase on a yearly basis. The reading follows a 1.9% decline in April. Despite the jump (the largest one-month gain since June 2011), the rise fell short of estimates calling for a 4.3% monthly increase and 6.1% yearly increase.
Further, the ministry noted that the top three industries leading the rise were (in order): transport equipment; general-purpose production and business-oriented machinery; and electronic parts and devices. The three industries that most offset the increase were (in order): information and communication electronics equipment; pulp, paper and paper products; and petroleum and coal products. Importantly, production is likely to remain solid with demand largely driven by exports to Asia, the U.S. and Europe. With increasing protectionism movements emerging across the globe, however, reports like these from Japan and China (as well as other foreign economies) will be important to watch.
On Thursday, the Institute of Supply Management (ISM) reported that the May manufacturing index came in at 54.9 (as explained above, anything above 50 represents expansion while anything below 50 indicates a contraction), up marginally from April’s 54.8 reading. The reading was a welcome surprise compared to expectations for a month-over-month slowdown to 54.4. Positively, May marked the 96th straight month of expansion in the overall economy and the ninth straight in the manufacturing sector.
Digging deeper, of the 18 manufacturing industries covered, 15 showed growth in May. The new orders index increased 2% (indicating a faster rate of growth) month over month to 59.5, production fell 1.5% to 57.1 (indicating expansion at a slower pace), employment grew 1.5% to 53.5 (indicating a faster rate of growth) and prices plunged 8% to 60.5 (increasing at a slower pace).
According to ISM Manufacturing Business Survey Committee Chair Timothy Fiore, “Comments from the panel generally reflect stable to growing business conditions, with new orders, employment and inventories of raw materials all growing in May compared to April. …The slowing of pricing pressure, especially in basic commodities, should have a positive impact on margins and buying policies as this moderation moves up the value chain.” The strong reading and positive outlook could be ammo for the Federal Reserve when it meets later this month to a) determine whether to raise interest rates and b) analyze economic prospects moving forward.
Also on Thursday, the Department of Labor reported that initial jobless claims for the week ending May 27 were 248,000 (a five-week high), an increase of 13,000 claims from the prior week’s revised numbers (revised up to 235,000 from 234,000 previously reported) and 9,000 claims higher than expectations. Importantly, the four-week moving average for claims (used as a gauge to offset volatility in the weekly numbers) increased by 2,500 claims from last week’s revised number of 235,500 (from 235,250 previously reported). Despite the rise, the trend for the labor market continues to be strong and suggests, at least in part, that the economy has perhaps picked up momentum in the second quarter. Importantly, this week’s data were not included in the survey period comprising the nonfarm payrolls report released on Friday (more below).
As a reminder, the government had updated jobless claims in a prior report, going back five years, as it does annually, to consider more accurate seasonal adjustments. The updates show layoffs have remained extremely low but were a bit higher than previously reported, mostly when considering data from 2016. Claims have remained below 300,000 — the threshold typically used to categorize a healthy jobs market — for an astounding 90 straight weeks (compared with 117 weeks under the older seasonal-adjustment process, according to the updated data), the longest streak since 1970.
On Friday, the Labor Department reported that the economy added 138,000 jobs in May, below expectations for an addition of around 184,000. Although the headline number was weaker than expected, the underlying numbers appear strong enough to support a Fed decision to raise interest rates — the question now perhaps becomes whether the economy can sustain a pace that will warrant an additional hike in September. Fed funds futures, a tool for wagering on rate shifts, were pricing in about 94% probability for a rate hike in June, whereas expectations for a second rate hike by September sit at only 24%.
Positively, the unemployment rate dipped again, to 4.3%, down from 4.4% in April (March was 4.5%). Unemployment is now at its lowest level since March 2001 — a big accomplishment for the Fed, which tracks unemployment when making decisions regarding whether to raise interest rates. Although the lower unemployment rate is encouraging, we note that a smaller share of Americans participated in the labor force this month — the labor force contracted sharply, with the number of Americans in the labor force falling by 429,000, suggesting that many able-bodied Americans are remaining on the sidelines despite what appears to be growing optimism within the economy.
Overall, the report was certainly short of spectacular, but is likely enough ammo for the Fed to move later this month (as suggested by the CME Group’s Fed watch tool). The bigger focus will now be on the longer term, questioning whether we are beyond peak employment and if the labor market can continue to carry the economy. In the immediate term, the report is unlikely to have much impact on the market, other than on financials (which are negatively impacted by declining yields), as strong earnings reports continue to fuel optimism regarding improving fundamentals for companies moving forward. You can read our full analysis of the report here.
On the commodity front, oil trended lower this week after failing to break above $50 over the weekend. Recall that oil initially sold off last week following OPEC’s Vienna summit. While the committee announced a nine-month extension to current production cuts (as expected), investors were disappointed, hanging onto hopes for deeper cuts and/or a longer extension. Adding to the pressure, Libya (which along with Nigeria continues to be exempt from the cuts) has recently increased oil output (back to near three-year highs) while U.S. producers continue to increase shale production.
On a brighter note, according to a Reuters report published on Thursday, OPEC held discussions last week at the Vienna meeting regarding increasing production cuts by an extra 1% to 1.5%. While we must be wary of such reports given that Saudi Arabia has tended to squawk when needed (i.e., when oil prices dip into the mid-$40s), the article at least provides some hope that OPEC could revisit deeper cuts should the current extension not live up to its intended purpose.
The commodity also got a boost on Thursday when the Energy Information Administration (EIA) reported that U.S. crude inventories fell by 6.4 million barrels last week, beating estimates for a drawdown of around 2.5 million barrels and confirming the bullish report from the American Petroleum Institute (API) the night before.
Given oil’s failure to break above $50 a barrel, consistent with our view that oil will trade in its established range, we would not be surprised to see oil prices drop lower into the mid-$40s in the short term. For now, we will be keeping an eye out for any news related to a potential deepening of production cuts and indications that OPEC members are complying with the enacted policy. For our view on how we intend to play the current oil volatility and how we expect it to impact our portfolio holdings, see our post from earlier in the week here.
Moving on to the broader market, as we mentioned, first-quarter earnings are winding down and have been relatively positive versus expectations, with 73.3% of companies reporting a positive EPS surprise. Total first-quarter earnings growth is up roughly 14% year over year versus expectations for an overall 14.11% increase throughout the season; of the 429 non-financials that reported, earnings growth is 13.3%. Revenues are up 7.2% versus expectations throughout the season for a 7.11% increase; 73.3% of companies beat EPS expectations, 20.4% missed the mark and 6.3% were in line with consensus. On a year-over-year comparison basis, 73.28% beat the prior year’s EPS results, 24.7% came up short and 2.02% were virtually in line. Information tech, health care and industrials have had the strongest performance to kick off the year versus estimates, whereas consumer staples and telecom have posted the worst results in the S&P 500.