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EARNINGS WATCH

Over and above the number of political, geopolitical, economical and financial concerns around the world, investors have suddenly gotten a lot more worried about profits as companies released Q3 results and commented on the outlook. The main issues all center on trade and tariffs which are currently hitting companies very differently depending on whether their industry is already impacted by tariffs or not, but nonetheless provide a fast-forward view of what is likely to happen if and when the U.S. applies the next blow to the trade war with China next January.

Q3 results and conference calls have morphed the trade wars from a mere concept to a stark reality: costs do increase as a result of tariffs and disruptions to supply chains.

So far, most manufacturers say they will be able to shovel their higher costs downstream but investors are realizing that this is a zero sum game for them: higher profits need to come from higher inflation which will draw higher interest rates which will hurt earnings multiples.

In coming weeks, markets will likely show high volatility as sentiment gyrates between the apparent cheapness of equities on current earnings and the potential profit and/or valuation impact down the shovelling line.

The October flash PMIs (below) indicate that the U.S. economy is booming entering Q4 and that “manufacturers remained more upbeat overall than service sector companies” (…) ”with overall business conditions improving at the fastest pace for five months”. This, for now, is more than offsetting higher costs from tariffs, transportation and oil, especially given that “factory gate charges continued to increase at one of the fastest rates since the first half of 2011”.

So far, so good…until you fast-forward and realize that a pretty severe margin squeeze looms under a scenario of a tougher trade war and/or slower demand. A positive scenario for margins (continued strong demand allowing cost pass through) necessarily means a negative scenario for inflation, interest rates and P/E multiples in a trade war environment. Suddenly, Trumpism is showing its dark side.

In the meantime, 82% of the 198 S&P 500 companies having reported beat consensus estimates, which is the highest beat rate on record going back to 1994. The beat factor is +4.9% (+3.9% yesterday) to boost the blended Q3 growth rate to 23.6% from +21.6% Oct. 1. Industrials are seen increasing their profits by 19.8%, up from +17.0% on Oct.1. Investors may be doubting the Q4 figures but sell side analysts see S&P 500 EPS up 19.4% in Q4 (+20.1% on Oct. 1) and up another 7.9% in Q1’19 (+8.1%). Industrials are expected to grown their profits 27.9% in Q4 and 9.6% in Q1’19. Margins angst has not reached the sell side yet.

Back to reality, trailing EPS are now $155.86, up 22.7% YoY. Pro forma the tax reform for the full 12 months, trailing EPS is about $158.35. At 2692, the S&P 500 Index is selling at 19.2 on the Rule of 20 P/E, a slight 4% undervaluation from the “fair” 20 level which is actually its stable long term median.

FLASH PMIs

Markit’s flash PMIs are very timely as some manufacturers are complaining about costs pressures, mainly from tariffs, and the more pressing need to pass rising costs down the line to the ultimate consumers.

The U.S. manufacturing PMI flashed a strong 55.9 in October, up from 55.6 with strong new domestic orders and employment growth. Importantly, factory gate prices “continued to increase at one of the fastest rates since the first half of 2011” indicating strong pricing power, hence continued good demand downstream. While this can feed consumer inflation, it will help cushion margins from operating costs pressures, at least for Q4.

Export demand remain weak which is also reflected in the Eurozone manufacturing PMI kissing the 50 no growth line while Services weakened to make Markit suggest a low 1.2% annualized GDP growth in Q4.

Japan PMI rose, however, thanks to improved export orders suggesting that China is hanging in.

U.S. private sector growth rebounds to three-month high, but intense cost pressures persist

Private sector business activity increased at a robust and accelerated pace in October. At 54.8, up from 53.9 in September, the seasonally adjusted IHS Markit Flash U.S. Composite PMI Output Index signalled the fastest rate of expansion since July.

Stronger overall business activity growth was driven by the service sector in October, which more than offset a slight loss of momentum in manufacturing.

Higher levels of business activity were supported by another sharp rise in new work. Survey respondents noted that improving domestic economic conditions were the main factor behind rising client demand.

Robust new business growth placed additional pressure on operating capacity in October, as highlighted by another modest accumulation of unfinished work. Payroll growth remained solid as firms continued to expand capacity, though the rate of private sector job creation eased to its slowest since June 2017.

October data pointed to the sharpest rise in operating expenses for five months. Survey respondents widely commented on higher cost burdens and stretched domestic supply chains in the wake of trade tariffs. Meanwhile, average prices charged by private sector firms increased at a robust pace, with the rate of inflation unchanged from September’s survey-record high.

Expectations regarding the outlook for business activity improved in October, with the degree of positive sentiment the strongest for five months. Manufacturers remained more upbeat overall than service sector companies.

At 54.7 in October, up from 53.5, the seasonally adjusted IHS Markit Flash U.S. Services PMI™ Business Activity Index indicated a rebound in output growth from September’s eight-month low. September’s reading had been affected in part by adverse weather.

Strong new order books remained a key driver of growth across the service economy. Latest data signalled a robust upturn in new work, which contributed to another accumulation of backlogs at service sector firms.

Despite a strong rise in new business, employment numbers increased at the slowest pace since June 2017. Some survey respondents noted that tight labor market conditions had held back their staff recruitment plans.

Meanwhile, input cost inflation accelerated to its sharpest since September 2013. A number of panel members cited the pass through of tariffs, alongside rising fuel bills and higher borrowing costs.

October data pointed to another strong month for the manufacturing sector, with overall business conditions improving at the fastest pace for five months. This was highlighted by the seasonally adjusted IHS Markit Flash U.S. Manufacturing Purchasing Managers’ Index™ (PMI™)registering 55.9, up from 55.6 in September and well above the crucial 50.0 no-change threshold.

Improved rates of new business and employment growth were the main factors boosting the headline PMI in October, which more than offset a slight slowdown in production growth.

The latest rise in payroll numbers was the steepest since December 2017, which survey respondents attributed to capacity pressures and greater business investment spending at their plants. Higher levels of new work largely reflected stronger domestic demand in October. New work from abroad remained close to stagnation.

Manufacturers continued to indicate a sharp deterioration in vendor performance during October, driven by stock shortages and robust demand for inputs. The recent phase of worsening supplier lead-times has been among the most intense seen since the survey began in 2007. There were widespread reports that stretched operating capacity and a spike in purchasing linked to trade tariff uncertainty had led to severe pressure on manufacturing supply chains.

Input cost inflation reached a five-month high in October, which was widely linked to metals tariffs and higher oil-related prices. At the same time, factory gate charges continued to increase at one of the fastest rates since the first half of 2011.

Eurozone business growth slowest for over two years, optimism hits four-year low

Flash PMI survey data indicated that the eurozone economy grew at the slowest rate for over two years in October as an export-led slowdown continued to broaden-out to the service sector. In a sign that the slowdown has further to run, companies’ expectations of future growth slipped to the lowest for nearly four years, with a near six-year low seen in manufacturing. Reduced optimism further dented hiring, hitting jobs growth. Price pressures meanwhile remained elevated, close to seven-year highs.

The IHS Markit Eurozone Composite PMI® fell to 52.7 in October, down from 54.1 in September and reaching its lowest since September 2016, according to the flash reading.

Manufacturing led the slowdown, with factory output rising only modestly to register the weakest monthly production gain since December 2014. However, service sector activity growth also slowed, easing to a two-year low, in a sign of the slowdown broadening out beyond the goods-producing sector.

The weakened rate of expansion was accompanied by a further deterioration in expectations for future growth to the lowest since November 2014. Optimism sank especially in manufacturing, down to the lowest since December 2012, but also dropped markedly in the service sector, where expectations for the year ahead were the joint lowest since December 2014.

Growth of new orders meanwhile eased to the slowest since August 2016, weakened by manufacturing orders falling (albeit only marginally) for the first time since November 2014. New export orders for goods decreased for the first time since June 2013. However, October also saw the second smallest rise in service sector new business for almost two years.

Backlogs of work rose at a marginally faster rate than in September but still showed the second smallest rise since January 2017. Factories reported the second successive monthly fall in backlogs (the first such back-to-back monthly decline since early-2015), contrasting with a slightly increased rate of backlog accumulation in the service sector.

Employment continued to rise, but the rate of jobs growth was the second-lowest for just over a year, easing to a 22-month low in manufacturing and three-month low in services.

Price pressures meanwhile remained close to a seven-year high. Input price inflation edged up to a four-month high, registering the third-largest monthly rise in costs since May 2011. A steeper rate of increase in manufacturing costs was in part offset by a small moderation in service sector input cost inflation, albeit with both sectors continuing to see elevated levels of price pressures.

Output price inflation edged slightly lower but also remained among the highest seen over the past seven years. While factory gate prices showed the smallest increase for 14 months, service sector charges once again rose at one of the strongest rates seen since the global financial crisis.

Other indices added to the softer picture: the amount of inputs bought by manufacturers barely rose, registering the smallest increase in three-and-a-half years. This reduced growth of demand for inputs in turn took some pressure off suppliers, meaning delivery times lengthened to the smallest extent since February of last year.

Within the eurozone, growth moderated especially sharply in Germany, sliding to the weakest since May 2015. The smallest gain in factory output for almost four years was accompanied by the slowest service sector growth since May. Notably, goods exports fell at the steepest rate since June 2013, down for a second consecutive month. Future expectations also sank to the lowest since late-2014, waning to a near six-year low in manufacturing and a three-year low in services.

Business activity growth picked up slightly in France but was nevertheless still the third-weakest seen since the start of last year. Although service sector activity grew at the fastest rate for four months, manufacturing output fell for the first time in 27 months, led down by an increased rate of loss of export sales. Business confidence fell in both sectors, down overall to the lowest for almost two years and dropping especially sharply in the goods producing sector.

Growth slowed across the rest of the single currency area to the weakest since November 2013, dropping in both sectors but slipping most prominently in the service sector. Future expectations meanwhile fell outside of France and Germany to the lowest since August 2013.

Chris Williamson, Chief Business Economist at IHS Markit:

The pace of Eurozone economic growth slipped markedly lower in October, with the PMI setting the scene for a disappointing end to the year. The survey is indicative of GDP growth waning to 0.3% in the fourth quarter, and forward-looking indicators, such as measures of future expectations and new business inflows, suggest further momentum could be lost in coming months.

The slowdown is being led by a drop in exports, linked in turn by many survey respondents to trade wars and tariffs, which appears to have darkened the global economic environment and led to increased risk aversion. It is therefore not surprising to see the slowdown broadening out across the economy, hitting the service sector.

The survey will make for uncomfortable reading at the ECB. Although the survey’s price gauges remain elevated and close to seven-year highs, the headline PMI has fallen to a level that would historically be consistent with a bias towards loosening monetary policy in order to prevent any further deterioration of economic growth.

Japanese goods producers observe strongest improvement in business conditions for six months

Flash Japan Manufacturing PMI® rises to 53.1 in October, from 52.5 in September.

• Growth of key macroeconomic variables (output, new orders and employment) all accelerate.
• Rates of input cost and output price inflation both quicken to multi-year highs.

Following a rather disappointing slew of PMI data over the third quarter, Japan’s manufacturing sector looks set to start Q4 on a more upbeat note. The latest survey indicated stronger expansions in all the key barometers of macroeconomic health, with output, new order and employment growth quickening since September. Furthermore, export sales rose for the first time since May, despite several respondents highlighting problems arising from global trade tensions.

That said, next month’s data will be important to assess whether the latest growth rebound is a transitory response to weakness resulting from recent natural disasters.

Draghi Says Balance of Risks Hasn’t Changed as Growth Wobbles

(…) “Incoming information, while somewhat weaker than expected, remains consistent with base case scenario of ongoing broad-based expansion of the euro-area economy and gradually rising inflation pressures,” the European Central Bank president told reporters in Frankfurt. The “underlying strength of the economy continues to support our confidence” in the gradual convergence of inflation toward the central bank’s goal. (…)

Durable Goods Orders Rose in September on Defense Spending

Overall orders for durable goods, manufactured products intended to last at least three years, increased a seasonally adjusted 0.8% in September from the prior month, the Commerce Department said Thursday. Economists surveyed by The Wall Street Journal had expected a 1.7% decline.

Defense aircraft and parts orders surged 119.1% from August, the largest monthly gain in military aircraft orders in more than three years, according to a Commerce Department official. Excluding defense demand, orders fell 0.6%. When excluding transportation equipment, demand grew 0.1%. (…)

An underlying business-investment gauge, new orders for non-defense capital goods excluding aircraft, fell 0.1% from August, but was up 6.6% on a year-to-date basis.

TECHNICALS WATCH

Hmmm…technicals are getting bad.

• Transport Stocks Join Small Caps, Banks in Correction Territory

As well as the Russell 2000, the KBW Nasdaq Bank Index, the Nasdaq Composite and the Nasdaq Biotechnology Index.

• The S&P 500 Index 200dma has cracked down. It needs a quick and strong rebound to reverse this dangerous change. The 600 dma has not turned down yet but is very flat. The Russell 2000 has just turned down a bit yesterday, as did the Wilshire 5000. Not good.
• Lowry’s Research Buying Power crossed below its Selling Pressure Index yesterday. Lowry’s argues that this does not “mark the end of the bull market, but be the result of a market correction similar to other corrections that have occurred since 2009.”
• CMG’s “Trade Signals” remain positive although the 13/34-Week EMA is wavering.