The rise in stock prices since February has lifted valuations to their highest level since the financial crisis. It is now time for economic fundamentals to show that such optimism is justified. Such proof was expected to begin to emerge with last week’s second quarter GDP report. What we got instead was a surprisingly weak estimate that was less than half the pace expected. Thankfully, consumer spending held up well, since it received no help from the business sector, which continued to liquidate inventories and postpone capital investment. Government spending even declined.
Inventories are an important swing factor, and continued drawdowns can lay the foundation for renewed stockpiling ahead, but only if business has the confidence that demand will be firm. Consumer confidence has softened a touch recently, but has not cracked, and could get a boost from gasoline prices, which are the lowest since April according to AAA. But, rather than confirming a widely expected bounce from the anemic first quarter, the GDP report raised new questions about the strength of the economy.
Corporate Earnings Dependent on Economic Activity
The expectation that corporate earnings growth will turn positive in the second half rests mostly on forecasts of accelerating economic activity. The apparent absence of momentum at the start of the third quarter raises a new element of doubt about those conditions arising. Second quarter earnings season is rapidly fading into the past. Although, as is typical, it was slightly better than expected, it was nevertheless quite weak, representing the fifth consecutive quarterly decline according to Factset.
Once again the energy sector is responsible for much of the weakness with earnings expected to decline 85 percent according to Factset. But looking ahead, energy was expected to be a large contributor to the pivot to growth as the year-over-year decline in prices was removed from the calculation. Unfortunately, the price of oil is not cooperating. Since its recent peak of $52.31 a barrel in early June, West Texas Intermediate (WTI) crude is in a bear market, having closed last week at $41.60, with most of the decline coming in July at the start of the third quarter.
Earlier optimism regarding the long anticipated rebalancing of the market has been tempered by persistently high inventories and renewed worries about the pace of demand growth against a backdrop of lowered global growth forecasts. In the third quarter of last year WTI averaged $52.36 a barrel and $47.55 in the fourth quarter. What was thought to be fairly benign comparisons suddenly looks more challenging.
Global Central Banks are at a Crossroads
Monetary policy also appears to be at something of a crossroads globally. In the U.S., after the Fed only gently nudged markets a little closer to another rate hike last Wednesday. Friday’s GDP report quickly took the wind from the hawk’s sails. What had been slightly better than even odds of a rate hike next March were quickly pushed out to September. In Japan, the Bank of Japan offered far less additional stimulus than expected, no doubt chastened by the ineffectiveness of its earlier move to negative interest rates, in what may be a tacit acknowledgement of the limitations of monetary policy. In the UK, the Bank of England (BOE) is widely expected to lower interest rates in response to the Brexit vote.
Read more here: New Questions Emerge About the Strength of the Economy