Is the market rally sustainable?

On the latest edition of Market Week in Review, Quantitative Investment Strategist Dr. Kara Ng and Research Analyst Brian Yadao discussed the recent strength in markets and the global economic outlook.

Markets hit record highs on expectations of Fed easing

Equity markets finished the week of July 8 on a peak, Ng said, with both the S&P500® Index and the Dow Jones Industrial Average establishing new all-time highs. This, she noted, happened despite a weakening global economy and predictions for a disappointing second-quarter earnings season. So, why are stocks rising steadily upward?

“It’s mostly because the market is putting all of its chips on expected easing by the U.S. Federal Reserve (the Fed) and other central banks,” Ng said, noting that she and the team of strategists at Russell Investments typically analyze the cyclical attractiveness of equities by three lenses: the economy, corporate earnings and monetary policy.

Global economic outlook appears bleak

The outlook for the global economy looks grim at the moment, Ng said, with global manufacturing Purchasing Managers’ Index (PMI) numbers at their lowest levels since 2012. Zooming into the eurozone in particular, she noted that German manufacturing orders recently plummeted by 8.6% on a year-over-year basis, sparking fears of a recession in the region’s largest economy. “Elevated trade tensions over the last few months probably led to this decline,” Ng said, explaining that the China-U.S. trade war has reduced demand for foreign goods, with Germany serving as a prime example.

Dismal projections for Q2 earnings season

Second-quarter earnings season kicks off July 15, Ng said, and early signs are pointing to less-than-stellar numbers. “The number of S&P500® Index firms issuing negative earnings guidance for the second quarter—87 total—is tracking to be the second highest in FactSet’s published history,” she explained. Overall, second-quarter earnings are projected to be flat or slightly negative, when compared to Q2 2018. “If Q2 2019 earnings come in negative, it’ll mark the second straight quarter of a decline in earnings, putting the U.S. at risk for an earnings recession,” Ng stated.

This is somewhat worrisome, she said, because earnings recessions and economic recessions usually happen simultaneously. However, this is not always the case, as evidenced by 2016, when there was a decline in earnings but no recession, Ng pointed out. “In a nutshell, the downgrades in earnings forecasts aren’t a great sign for the health of the economy, but are in no way a death sentence,” she said.

Fed rate cut looks increasingly likely after Powell testimony

June’s strong U.S. jobs report, coupled with a slightly stronger-than-expected increase in the Consumer Price Index (CPI), presented an opportunity for Fed Chair Jerome Powell to communicate that a July rate cut may not be quite as likely—but he did the exact opposite in testimony before the U.S. Congress, Ng said. “Powell flagged business uncertainty, global trade tensions and some softer growth numbers as risks to the economy, and also noted that the link between inflation and unemployment has broken down recently,” she stated.

Even more notable, the Fed chair said that the central bank’s monetary policy may not be as accommodative as originally thought, Ng noted. “Put together, this means the Fed is probably on track to cut interest rates at the end of the month,” she said. While the expected easing is a near-term positive for equity markets, Ng believes that a greater level of stabilization is needed for both the global economy and earnings in order for the current rally to be sustainable.

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