The fourth quarter of 2019 should tell us a lot about what to expect for 2020, as the debate on whether there will soon be a recession continues.
Wall Street seems cautious but measured on the fourth-quarter outlook.
"Separating facts from fears" is the name of the game when it comes to a recession, wrote a team of strategists at Franklin Templeton investment. The inverted yield curve, with the 3-month treasury yield at 1.7% and the 10-year yield at 1.52%, are the main data points causing fear. Investors have flocked into long-term government debt, sacrificing higher yields and expecting extremely low inflation. But the S&P 500 has risen 17.3% year to date, as two Federal Reserve interest rate cuts have propped up equity prices and the expectation of one more isn't hurting. But "Franklin remains relatively positive on their outlook for equities," as several economy data points are strong.
Let's get away from the recession debate for a second. Maybe understanding what to expect in the fourth quarter will guide us better.
Many cite the currently "strong" consumer, which comprises roughly 70% of U.S. GDP, as one reason for some level of bullishness on stocks. The unemployment rate is currently around 3.7%, incredibly strong historically.
Also, while manufacturing results have looked bleak, it is the services sector, recorded by the ISM non-manufacturing index, that comprises 66% of the country's output (consumer services are reflected in the services sector). The non-manufacturing index showed a reading of 52. Anything above 50 represents positive growth. Still, economists were expecting 55. But "one can argue that the manufacturing side and earnings are currently in a recession, but the service economy is not," Franklin Templeton said.
How about that manufacturing situation? The ISM manufacturing index showed a contraction for September, with a reading of 47.8. That missed economists expectations of 51 and decelerated from August's reading of 49, also a contraction.
Businesses are clearly investing less than they were in 2018, which can cause hiring numbers to fall. ADP said the U.S. economy added 135,000 jobs in September, missing economists estimates of 142,000. The Bureau of Labor Statistics said the U.S. added 136,000 non-farm payrolls for the month, missing estimates of 145,000.
The probability of one more interest rate cut in 2019 is currently at 76%, but many agree that further rate cuts cannot be very effective, as rates are already very low. Plus, some have even said another rate cut could cause excesses in household finances and some risk assets.
While the economy is currently on strong footing, the data are declining. GDP growth was near 4% in August of 2018, but has decelerated to 2%, with some economists now looking for growth of below 2%. Inflation remains stubborn, at roughly 2%.
Wall Street is concerned about several factors. Without a trade agreement between the U.S.' President Trump and Chinese leader Xi Jinping, the tariffs set to go into effect in December could be detrimental.
"A further escalation beyond the tariff increases already in the pipeline would markedly increase the risk of recession," wrote UBS Chief Investment Officer of Wealth Management Mark Haefele. Positively, "a lasting solution would enhance the potency of recent central bank easing."
Business confidence is another issue. Without knowing what to expect on the tariff front, business executives may be hesitant to invest. "We don't see a recession on the horizon, but I think we are entering a period where we have to be careful that we don't talk ourselves into one," said Tony Bedikian, head of global markets at Citizens Bank.
What to Expect in Q4
Earnings growth is excepted to decelerate to 3.6% year-over-year, according to FactSet. And 2020 earnings growth is expected to be 5.6%.
Those two numbers are vulnerable. Not only has earnings growth revisions downward been a theme in the past year or so, but decelerating economic data may indicate corporate revenue and earnings will come in below expectations.
Here's the key:
"Guidance about the fourth quarter and into early 2020 on what companies are planning" is the thing to watch over the next few weeks, Bedikian told TheStreet.
How to Invest
Many on Wall Street are tilting portfolios to the defensive side.
The S&P 500's average forward price-to-earnings multiple is a touch above 18, slightly high historically. But treasury yields have negative real yields, meaning that they are lower than the inflation rate.
Still, "Franklin is investing in safe haven assets."
RBC Capital Markets' equity research team noted in a late September report that dividend stocks can provide premium yields compared to treasuries, with yields ranging from 2% to 5%.
UBS Haefele recommends being "overweight" TIPS (treasury inflation protected securities). They compensate investors when inflation rises, but can provide a lower yield than standard treasuries.
On defensive stocks, it's also important to note consumer staples are no longer exactly cheap. The Invesco Consumer Staples ETF (XLP - Get Report) is up 26% in 2019, easily outpacing the S&P 500, with an average forward earnings multiple of 23.