Q3 Earnings Have Been Great but the Market is Still Not Happy

Companies including Adobe, Goldman Sachs, Johnson & Johnson and Procter & Gamble reported strong earnings last week.  Notably, Procter & Gamble reported that high demand, rather than price increases, drove its strongest quarterly sales growth in five years.  Of the S&P 500® companies which have so far reported earnings, approximately 90% have exceeded analyst estimates.  Company commentaries reveal the limited impact of tariffs to date while concerns remain if the impasse continues.  U.S. and China apparently plan to meet in November; European and other Asian countries are providing support for the U.S. position regarding unfair bidding practices for infrastructure projects. Unfortunately more than corporate earnings affect the markets and currently there are a few things the market is watching.

Geopolitical events continued to trump strong earnings as new developments related to Saudi Arabia and Federal Reserve commentary weighed on the market.   For the week, the Dow Jones Industrial Average and S&P 500® Index eked out modest gains (0.41% and 0.02%, respectively).  Technology and small cap stocks fell fractionally as the Nasdaq dropped 0.64% and the Russell 2000® Index dropped 0.30%.

The disappearance and presumed murder of journalist Jamal Khashoggi has become a significant political and economic issue; Saudi Arabia has acknowledged that he died ‘during a fight’ in the Saudi consulate in Istanbul.  The U.S. and its allies have not yet determined their responses; they will likely balance criticism of Saudi Arabia while maintaining relationships with the Kingdom as an offset to Iran’s role in the region.  Actions by the business community are perhaps sending a more important message; many high profile companies have withdrawn from attending and/or speaking engagements at next week’s “Davos in the Desert” financial summit in Riyadh; the summit is intended to showcase Saudi Arabia to attract new business investments to diversify their economy.  Furthermore, Saudi Arabia has invested significantly in Technology startups; retaliatory actions could dampen investments in venture capital deals.  And, perhaps coincidentally several companies, including Uber, Lyft and data mining Palantir Technologies, this week announced plans for IPOs in 2019; two years ago, Uber received $3.5 billion in funding from the Public Investment Fund, Saudi Arabia’s sovereign wealth fund.

Wednesday’s release of minutes of the most recent Fed meeting revealed mixed opinions on future interest rate increases needed to maintain a neutral position.  The markets continue to struggle in evaluating the impact of higher interest rates; the Fed, though, seems steadfast in setting a course of gradual, data-driven rate increases.  The big picture here suggests that the recent spike in interest rates may reflect investor concerns about the strong equity market rally; that is, the overvaluation of recent performance leaders may have unnerved investors.  For example, even though Netflix recently rose after reporting higher-than-expected new subscriber growth, ended the week in bear market territory, more than 23% below its all-time high in July. The market is more concerned with the Federal Reserve reducing its balance sheet (selling or letting Treasury bonds mature) causing bonds prices to go down and yields to rise. This Federal Reserve’s balance sheet ballooned in the financial crisis from $700mm to more than $4.5 Trillion from Quantitative easing. This is uncharted territory for our federal reserve and the federal reserves around the world who followed the U.S game plan during the financial crisis.  

When President Trump says the Fed is raising rates too quickly, he is not just talking about the rate increases at the Feds meetings but rather what the Fed policy is in totality and the affect it is having on prevailing interest rates.  The Federal Reserve has never been in this situation before and must proceed with caution.  We predict they will either hold on rate increases or slow their bond selling program.  Both are important for long term economic stability, but this too will take more time than anyone ever thought.  The world is watching to see how we deal with this before they pursue the same policy.  Time will tell, but we believe the Federal Reserve will address this situation in the next few months.

As with past geopolitical crises, the current crisis too will likely resolve over time; likewise, the sell off this month will trigger market activity. The Federal reserve does not want to slow the economy so much that is stalls. Why?  Earnings conference calls reinforce expectations for continued economic growth in 2019; and, companies, after reporting earnings, will be free to re-enter the market for stock buybacks.  Current prices may provide an important support for the market as earnings season progresses and geopolitical events unfold.

Source: Strategas and Pacific Global Investment Management Company

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.


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