Stock Recovery Sputters as Peril Lurks Ahead for Markets

(Bloomberg) -- After a tumultuous Monday, stocks temporarily shook off some of the malaise that saw shares tumble from New York to Sydney. But an extended bout of smooth sailing just wasn’t in the cards.

While the S&P 500 broke a six-day losing streak on Tuesday with a 1.3% advance, it was down 1.4% as of 10 a.m. in New York on Wednesday. The VIX rallied back above 20, reaching as high as 23.67. That’s as everything from economic growth to bond-market signs and valuations is signaling there could still be trouble ahead for U.S. equities, according to strategists and investors.

RBC Capital Markets’ head of U.S. equity strategy, Lori Calvasina, is focusing on upcoming quarters’ corporate earnings, now that almost 80% of S&P 500 companies have reported.

“There’s a lot underneath the surface that we don’t like about this reporting season,” Calvasina wrote in a note Aug. 6. In particular, sales and earnings aren’t beating estimates by much, and what there is seems largely driven by cost-cutting, she said. Forecasts for the fourth quarter and 2020 haven’t come down very much yet, she added.

Citigroup Inc.’s Tobias Levkovich shares the concern, and cut his earnings forecast for the S&P 500 for 2019 and 2020 on the idea that U.S.-China trade tensions will last long enough to hurt a potential rebound in U.S. corporate profits.

Signals from the bond market aren’t helpful either.

Brian Barish of Cambiar Investors LLC notes that the yield-curve inversion is still sending a message of no confidence in the medium-term economic outlook. U.S. 10-year Treasury yields bottomed in 2016 around 1.4%, and “if they fell below that level it would be fairly disquieting to me,” he said. The yield was at 1.62% Wednesday, down nearly 40 basis points since the end of July.

Those worries dovetail with a report from JPMorgan Chase & Co. on Aug. 2, before Monday’s sell-off, saying that a major disconnect between bonds and equities had formed. Yields were pricing in a strong probability of a recession coming, but stocks were more optimistic.

“One of the two markets is likely to prove wrong,” strategists led by Nikolaos Panigirtzoglou wrote.

Stocks also appear to be attaching a premium to manufacturing sector activity. UBS Group AG estimates show that equity markets are implying an ISM Manufacturing level of 55, versus the July reading of 51.2. That’s the largest gap in nearly four years, strategists led by Stuart Kaiser wrote in a note.

It “suggests downside risk if growth slows,” Kaiser said in an email.

Given the current level of economic growth, the S&P 500 should be at about 2,700, according to Deutsche Bank AG’s model. Leading indicators point to a further slowdown, even before taking into account recent escalation of trade tensions, strategist Binky Chadha wrote in a recent note. The S&P 500 closed at 2,881.77 Tuesday.

Fed Optimism

For Calvasina at RBC, “the 7% drop in the S&P 500 in May didn’t solve the stock market’s crowding and valuation problems.” A drawdown more severe than 10% may be needed to fix them, she said.

To be sure, trade tensions have been around for many months now, and the S&P 500 has still gained 14% this year. Optimism from potential Federal Reserve rate cuts spurred Goldman Sachs Group Inc. last week to raise its 2019 target for the gauge to 3,100, and many other strategists’ predictions aren’t too far off from that level.

Still, there are concerns about the trade war’s consequences as the effects trickle through to the economic and financial systems.

“If the tone on trade doesn’t improve soon, we may be looking at a full on growth scare for the stock market in the months ahead which could take the S&P 500 down as low as 2,436 or 2,550,“ RBC’s Calvasina said. She maintains her 2019 target of 2,950 on expectations of further Fed easing and a shift in tone on trade.

--With assistance from Rita Nazareth.

To contact the reporter on this story: Joanna Ossinger in Singapore at jossinger@bloomberg.net

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Andreea Papuc, Ravil Shirodkar

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