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Brexit Deal Adds To Optimism On The Geopolitical Front

JJ Kinahan

Investors have something to cheer about this morning in addition to an encouraging start to earnings season.

News that Britain and the European Union have struck a preliminary Brexit deal boosted market sentiment. While the deal faces opposition from key lawmakers representing Northern Ireland and still has to be approved by Britain’s parliament and other EU member states, the draft deal seems to have gone a long way toward soothing investors worried about the state of the global economy.

Because Britain is one of Europe’s largest economies, having a deal in place to smooth the divorce is an important step toward easing uncertainties about what Brexit will mean for the European economy and its effects on the rest of the global economy. 

Aside from the U.S.-China trade war, Brexit has been one of the biggest worries hanging over Wall Street. Now, it seems that progress has been made on both fronts. Still, the market isn’t out of the woods yet, especially on the trade front.

The stock market was pulled in different directions Wednesday as disappointing economic data and trade concerns outweighed a fairly encouraging start to the earnings season.

With the U.S. consumer accounting for the bulk of the nation’s gross domestic product, it’s understandable why a report showing retail sales in September fell 0.3% to mark their first drop in seven months created some angst, helping to send stocks lower and boosting demand for U.S. government debt and gold. 

At the Cash Register

While the headline number does add to the narrative of slowing U.S. economic growth, taking a deeper look might provide investors with the sense that things might not be as bad as the headline figure might suggest. First, August’s number was revised higher, from 0.4% growth to 0.6%. And secondly, the September numbers showed that retail sales still rose more than 4% year-over-year. And when you strip out auto sales, September’s number was lower by just 0.1%. Also, keep in mind that one report isn’t a trend.

Interestingly, the Consumer Discretionary sector was the S&P 500 Index’s (SPX) best performer Wednesday despite the retail sales data. Perhaps the fact that clothing and clothing accessories sales actually rose 1.3% helped. And the Fed’s Beige Book, which was published Wednesday, said that household spending was solid and non-auto retail sales increased modestly since its last summary of comments from business contacts. (See more on the Beige Book below.)  

More Trade Wrangling

In addition to the retail sales data, it seems that trade concerns also dampened market sentiment Wednesday amid a raft of headlines that indicate market worry and volatility about the trade war between the world’s two largest economies probably won’t go away for a while despite last week’s progress.

China threatened to retaliate after the house passed three bills supporting pro-democracy protesters in Hong Kong. The Wall Street Journal reported that questions remain about how much more U.S. farm products China will buy, the time frame of such purchases, and what the United States might have to concede to secure them. Meanwhile, President Trump said he probably wouldn’t sign any trade deal before meeting with Chinese President Xi Jinping in Chile next month.

Earnings Season Off to a Decent Start

So it seems that the drumbeat of headlines on trade continues to have substantial sway over the market. But at the same time, investors and traders now have something more substantive to sink their teeth into—namely hard numbers from companies in their earnings reports.

Since earnings drive markets over the long run, this earnings season can provide market participants with hard numbers and commentary from executives with their fingers on the pulse of the business. That can give arguably better perspective on where the market and economy could be headed than the back-and-forth headlines on the trade situation that can change on a moment’s notice until an actual deal gets signed.

So far, most of the S&P 500 companies that have posted Q3 reports have beaten expectations. Among them, Bank of America Corp (NYSE: BAC) and United Airlines Holdings Inc (NASDAQ: UAL) helped move the market higher Wednesday after reporting better-than-expected profit.

Netflix Inc (NASDAQ: NFLX) continued the drumbeat of earnings beats after Wednesday’s close. Its shares rose 8% after the streaming company announced it added more paying subscribers. While it added more international subscribers than expected, its domestic subscriber growth was weaker than forecast. 

Recall that last quarter, the new subscriber number came in well below expectations, and the company reported its first decline in U.S. subscribers in eight years. That disappointment came amid plans by rival content providers—including Walt Disney Co. (NYSE: DIS), Apple Inc. (NASDAQ: AAPL), AT&T Inc’s (NYSE: T) WarnerMedia and Comcast Corp.’s NBC Universal (NASDAQ: CMCSA)—to enter the market for streaming content.

But while yesterday’s solid earnings and bounce in subscriber additions might have investors breathing a sigh of relief, NFLX did acknowledge that competition will be a headwind, at least in the short term.

Meanwhile, Morgan Stanley (MS) became the latest bank to beat earnings estimates amid solid results in its trading business. That follows encouraging results from JPMorgan Chase & Co (NYSE: JPM), Citigroup Inc (NYSE: C), and Wells Fargo & Co (NYSE: WFC), as well as BAC.

Not all was rosy in earnings land though. International Business Machines’s (NYSE: IBM) shares were getting taken out to the woodshed this morning despite earnings coming in slightly ahead of expectations. IBM missed on revenue forecasts as it reported its fifth quarter in a row of falling sales. 

In economic news this morning, September housing starts came in weaker than expected, at a seasonally adjusted annual rate of 1.256 million units. That was below a Briefing.com consensus of 1.306 million. But building permits for the month were better than expected, posting 1.387 million units compared to a consensus expectation of 1.350 million.


FIGURE 1: RISK-OFF? Wall Street’s main fear gauge, the Cboe Volatility Index (VIX), rose a bit on Wednesday as investors worried about U.S. retail sales and the continuing U.S. China trade war. But VIX's current 13-handle is well below the 20 mark (purple line)—seen by many as the "risk-on/risk-off" point. Given all the things investors have to worry about, it may be the case that the VIX is lower than where it would otherwise be because market participants are counting on the Fed to lower rates further if the economy gets into trouble. (See more on that from the IMF below.) Data source: Cboe Global Markets. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

The Color of the Economy: According to the Fed's latest summary of anecdotal accounts from its districts, U.S. economic growth seems to be slowing. The central bank said the economy expanded at a “slight to modest” clip since its prior Beige Book amid varied business activity across the nation. That wording seemed a bit weaker than the last Beige Book, when the Fed said reports suggested the economy grew at a “modest pace” through the end of August. Manufacturing continued to edge lower amid trade tensions and slower global growth, and agricultural conditions deteriorated amid adverse weather, weak commodity prices, and trade disruptions. But freight shipments stabilized, bankers in many districts reported moderately rising loan volumes, household spending was solid, and non-auto retail sales increased modestly. “Business contacts mostly expect the economic expansion to continue; however, many lowered their outlooks for growth in the coming six to 12 months,” the Fed said. 

What are the Chances? As of this morning, the probability among traders of the Fed lowering its key short-term interest rate at its next meeting has risen to 88% from 73.8% a couple days ago and from 21% a month prior, according to CME Group’s FedWatch tool, which tracks the futures market. The probability jump was probably helped by the disappointing retail sales numbers, which give the Fed more room for increasingly dovish policy—at least in the minds of some market participants. But given the division in the Fed we saw over the last interest rate cut, and the fact that the U.S. economy isn’t doing that badly despite some headwinds, it’s interesting to see such a marked swing in rate cut expectations. Notably, in a speech yesterday, Chicago Fed President Charles Evans called the economy—and the current target rate—“in a good place.” He said that, while a case can be made for further accommodation, he believes the two rate cuts this year were enough for the time being.     

Are Stocks Overvalued? Ask the IMF. The faith that investors and traders seem to have that the Fed will come to the rescue of the market by propping up the economy with dovish monetary policy may be contributing to stocks being valued too highly compared with the fundamentals, the International Monetary Fund said in a report Wednesday. Implied volatility has been relatively contained this year as corporate earnings and payouts have kept it in check, the IMF said. But at the same time the current level of volatility may not be factoring in external issues like trade tensions and global economic uncertainty, the organization said. 

The divergence could partly be due to a belief that monetary policymakers will basically provide insurance against sharp stock price declines by responding quickly to tightening financial conditions, according to the report. “Equity markets appear to be overvalued in Japan and the United States,” the organization said. “Since April, U.S. equity prices have increased whereas fundamentals-based valuations have declined as higher uncertainty about future earnings outweighed the boost from an expected rebound in earnings and lower interest rates.”

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