With a Little Help From My Friends: On Africa, Economy and Earnings

Key Points

  • Thank you stock market for behaving while I was on an African vacation!
  • Economic data has been mixed-to-better; supporting new highs for stocks.
  • Can earnings growth squeak its way back into the green in the third quarter?

I just returned from a family vacation to Africa, with stops in Cape Town, a game reserve in the Sabi Sand/Kruger National Park, Victoria Falls in Zimbabwe, and two distinct game reserves in the Okavanga Delta in Botswana. We awoke every morning pre-dawn to uniquely stunning vistas, but the sunsets were even more remarkable. On most evening game drives, our guides stopped their vehicles to set up for our “sundowners”—cocktails in the bush, with spectacular birds everywhere, and dangerous wildlife often perilously close. By the finale to our trip, we had seen everything on our bucket list—including the “Big 5” and even a “kill” of a kudu by a pride of lions (which was admittedly very difficult to watch…but that’s nature at work).

I have always loved elephants—even more so now, having shared our lodges with many. Needless to say, when a bull elephant is standing in the path to your room, you wait for him to move. The experience was priceless for all in our little family of four—made even more special thanks to the cooperation of not only the animals, but also the stock market while I was away!

Stock market’s cooperation

I will never forget my August vacation on Nantucket in 2011, when the markets went into an utter tailspin. I spend my entire vacation in front of my laptop and on the phone. The disconnect to the outside world while in Africa would have made an experience like that quite difficult, so I’ll be forever grateful for the market’s cooperation. I was on the grid sufficiently enough to keep up with the economy’s and market’s goings-on (and sadly the election), and I thought I’d get back in the saddle today with an update on how both the economy and corporate earnings have fared in the past couple weeks.

Economy remains a mixed bag

We closed out July with a disappointing second quarter gross domestic product (GDP) report. Real (inflation-adjusted) GDP rose at a 1.2% annual rate, less than half the 2.5% consensus. However, inventories subtracted 1.2 percentage points, so the details were better than the headline; while the inventory drag is positive for future growth. That helps to explain why expectations for the third quarter are markedly better, as you can see below in the well-watched Atlanta Fed’s GDPNow Tracker.

That stronger-than-expected growth is consistent with economists’ consensus third quarter real GDP growth estimates, as per Bloomberg. From a late-July low of 2.2%, expectations have moved up to 2.5%; albeit still south of the Atlanta Fed’s Tracker.

Since the release of second quarter GDP, July’s economic data was mixed-to-better. Wage growth picked up, as did core personal consumption expenditures (PCE) inflation. The regional PMI indexes were mixed and both the manufacturing and services ISM indexes did tick down. However, they both remain comfortably in expansion territory and the dips followed huge jumps in June. The big whammy was the July employment report, showing payrolls increased by 255k, significantly above the 180k consensus. But there was bad news in the form of a drop in nonfarm business productivity, which is holding down potential real GDP growth. Retail sales also disappointed with no growth in July; however it followed a strong prior few months, and the data is highly volatile.

This mixed performance has been reflected in the Citigroup Economic Surprise Index, seen below, which has consolidated some of its prior surge. As a reminder, the index measures how economic data is coming in relative to expectations (it’s not a measure of absolute economic growth).

Source: FactSet, as of August 12, 2016.

On to earnings

According to Thomson Reuters I/B/E/S data, S&P 500 bottom-up earnings for the second quarter were yet again in negative territory in year-over-year terms, for the fourth consecutive quarter. As you can see in the table below, the not-yet-official second quarter experienced a 2.5% decline in S&P 500 earnings; with the largest drag coming from the energy sector (by far). This near-final result is quite a bit better than the nearly -6% which was expected in early July.

Source: Thomson Reuters, as of August 12, 2016.

On the surface, this doesn’t seem to square with the market’s strong performance since the June lows. But remember what I often say: the market cares more about “better or worse” than “good or bad.” On that note, below you can see the “beat rate” scorecard for second quarter earnings—a better-than-average 71% for the S&P 500 overall; with significant “wins” for the health care and technology sectors.

Source: Thomson Reuters, as of August 12, 2016.

Looking ahead, at this stage, estimates for the third quarter are not quite back into positive territory, as you can see below. However, if the beat rate statistics remain consistent, the bar may be set sufficiently low for growth to ultimately move back into the green.

Source: Thomson Reuters, as of August 12, 2016.

In sum(mer)

The summer lull in volatility has been supported by decent economic news alongside slightly better-than-expected (albeit still-negative) earnings. Economic data will continue to be watched with keen market eyes given the likely impact on Federal Reserve policy. We continue to believe a rate hike is on the table for this year. The combination of Fed policy uncertainty and the contentious election season could mean the recent lull in volatility will not persist into the fall.

Important Disclosures

© Charles Schwab

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