The Good. The rebound in corporate profitability has exceeded the most optimistic expectations. With the Q2 reporting season almost complete, earnings estimates for the quarter and the year have been revised up substantially. The first chart below shows that with almost 90% of companies reported, U.S. Q2 earnings recorded a +93% y-o-y growth rate with upgrades to every sector. In June, before the beginning of company announcements, expectations were for more muted growth of just above +50%. The second chart below plots the y-o-y earnings momentum of the European listed companies. Earnings are now expected to increase +148% from a year earlier with a record number of companies that have announced beating both revenue and earnings expectations.
Source: Strategas Research Partners
Source: Strategas Research Partners
Despite rising concerns over inflation and the impact of the Delta variant, the U.S, Leading Economic Indicator advanced for the 15th consecutive month and is now firmly above pre-Covid levels. While second derivative growth concerns (the rate of growth is slowing) continue to be fed by mixed economic data and tough y-o-y comparisons, absolute economic growth remains strong as evidenced by real-time estimates of U.S. Q3 GDP growth at +6%.
Source: Strategas Research Partners
The Bad. It should not come as a surprise that with rising Covid-related disruption, exploding headline geo-political tensions and humanitarian crisis, and continued high readings of inflation even as growth normalizes, that business sentiment is starting to respond negatively. The chart below shows that U.S. small business sales expectations moved lower in July with a small majority of respondents now expecting business volumes to decline over the next 6 months. While sales expectations have improved drastically off the 2020 low, there appear to be several headwinds, with inflation being one of the most commonly cited issues, that are weighing on small business outlooks.
Source: Strategas Research Partners
Commentators are also carefully monitoring the recent slowing of Chinese economic data (charts below) to ascertain whether it provides a useful map for the recovery path of the Western countries. Rising Covid disruption and a clear government policy switch to promote social cohesion at the expense of individual freedom is having a tangible impact on China’s recovery path. While mainly self-inflicted, the economic developments in the second largest global economy cannot be ignored.
Source: Strategas Research Partners
The Starting to get Ugly. The financial market reaction to the evolution of mixed economic data has taken a turn for the worse over the past couple of weeks. To be very clear, the developments which we are about to discuss are not yet at a point that may be described as fatal to the positive economic recovery narrative and continuation of further market gains. Consolidations and shallow market corrections are a very normal feature of financial market activity. However, the below charts need to be monitored carefully for further deterioration that may signal that a more defensive portfolio posture should be adopted.
The chart below is one that we produce regularly to monitor the underlying health of the equity advance. While the equity market is hovering close to all time highs, the percentage of stocks participating in this advance has continued to decline. Market breadth is starting to get sloppy. At 76% at the end of last week, the percentage of S&P companies above their 200-day price average is now the lowest since Biden took office as U.S. President.
Source: Bloomberg Finance
This developing weakness is not just confined to the economically sensitive Value stocks either. The chart below of the breadth of the Nasdaq 100 – dominated mostly by the largest technology companies in the U.S. – also confirms the deteriorating trend in the number of companies participating in the general market advance.
Source: Bloomberg Finance
The chart below is also one that we reference frequently to gauge if there is any rising financial stress. The spread between the price paid from non-investment grade (BB) borrowers and investment grade (BBB) borrowers provides a useful clue as to any rising investor concerns over the health of the former which should be the first to feel the pressures of any economic pinch. The rise over the past couple of weeks has been modest in an absolute context, but we cannot ignore that it is close to touching a six-month high.
Source: Bloomberg Finance
Finally, the U.S. 10-year yield refuses to respond higher to generally strong economic data, inflation remaining stubbornly high, or indications that the Federal Reserve is about to announce a tapering of its long-entrenching bond buying programme. At the same time, it should be mentioned that neither has the yield yet made new lows for the year. It remains range bound, reflecting the uncertainty of market participants.
Source: Strategas Research Partners
Our current expectations remain that the current recovery should prove sustainable beyond the tapering of monetary and fiscal stimulus. If correct, the current growth scare has created more attractive investment opportunities as the fast money has indiscriminately exited more economically sensitive segments of the equity market. The chart below shows that short-term investor flows (over last 2 months) into the cyclical equity sectors is at levels last seen at the height of the Covid scare in March of last year. We suspect that the near-term data will be crucial to determining the path of financial markets into year-end.
Source: Strategas Research Partners
