Schwab Market Perspective: Canary in the Coal Mine…or Simply Clouds on the Horizon?

Key Points

  • U.S. equities have trended higher, largely ignoring weakness in the manufacturing sector and cheering looser monetary policy, but the recent pullback could be a sign of things to come.

  • While manufacturing and business indicators have weakened, the consumer remains solid, bolstered by a strong labor market. After cutting rates, the Federal Reserve held its dovish stance; but vulnerabilities remain for investors, including a worsening trade situation.

  • The Japanese economic outlook is mixed, with monetary, fiscal and trade policies all intersecting.

“History is a vast early warning system.”
― Norman Cousins

Warning Signs

Investors have largely ignored mounting economic warning signs, pushing U.S. stocks steadily higher over the past two months (albeit with some minor bumps along the way). A perceived softening of trade tensions between the U.S. and China (prior to President Trump’s most recent tariff threat), along with a dovish Federal Reserve, has bolstered investor sentiment. We remain positive but are getting a bit concerned that markets have gone too far, too fast—with investor sentiment reaching extreme optimism levels, according to the Ned Davis Research Crowd Sentiment Poll. Additionally, the manufacturing sector—which is more sensitive to trade and tends to be a leading indicator of economic activity—has shown signs of weakness; yet, this hasn’t been reflected in investor behavior. Due to the increased likelihood of a decent-sized pullback in the near future in our view, as well as the newly-imposed 10% tariffs on $300 billion in Chinese goods scheduled to go into effect on September 1, we continue to suggest investors remain patient and diversified, with a bias toward large cap stocks and a defensive tilt regarding sector allocations (See Sector Views for more).

Brief slump or signal for the future?

The aforementioned softening in manufacturing may start to negatively impact the services sector and broader economy. Markit’s Manufacturing Index fell to 50.4 in July, accompanied by the Institute for Supply Management (ISM) Manufacturing Index’s drop to 51.2.

Manufacturing weakening

Unsurprisingly, both surveys indicated that trade was a significant contributor to the weakness in manufacturing activity; and we are concerned it may start to bleed through to other areas of the business world. Both the CEO and NFIB outlooks have struggled of late. According to Strategas Research Group, planned capital expenditures based on Fed regional surveys have declined sharply, which historically has led to a decline in actual capital spending.

Business confidence weakening