- Manufacturing is under pressure but services look okay; manufacturing matters much more for equity markets than it does for the U.S. economy.
- Most sectors look set to struggle this earnings season, but healthcare and utilities are two bright spots.
- There are structural and technical reasons why value has underperformed growth; we prefer focusing on cyclicals relative to defensives.
- 2020 earnings estimates are still too high; as these decline in the coming months, focus on cash flow and total yield.
The economic backdrop in 2019 has been characterized by weakness in manufacturing being offset by the resilience of services and the health of the consumer. However, the past few weeks have seen a deceleration in the pace of employment growth and a notable softening across the nonmanufacturing sector. The idea that this expansion will continue has been predicated on manufacturing weakness remaining contained, but this dynamic is increasingly being called into question.
Digging a little deeper, there has been a notable divergence between the hard and soft data. While the soft, or survey data, has come under pressure, the hard data has been better than expected (Exhibit 1). At the end of the day, the data in aggregate suggest that U.S. economic growth is slowing, but not stalling. However, this is not necessarily true for the rest of the world, which is far more exposed to manufacturing and trade than the United States. Forecasts suggest that the eurozone and Japan saw meager growth in 3Q19, while emerging markets were a bit of a mixed bag. The risk of recession outside of the U.S. has been rising.
But why does this matter for equities? The S&P 500 is far more exposed to global manufacturing activity than it is to services, and weaker manufacturing data matter for profits. For this reason, equity markets tend to exhibit a strong positive correlation to manufacturing survey data, which accounts for the majority of the soft data in the U.S. The divergence between soft and hard data suggests that sentiment has been a key driver of recent volatility, as fundamentals have not disappointed to the same extent as the surveys. That said, given that uncertainty continues to permeate the air, the more cautious tone in markets seems warranted.