Stocks Decline as Political Uncertainty Fuels Volatility

Charles Schwab: On the Market

Posted: 12/1/2017 4:15 PM EST

Stocks Decline as Political Uncertainty Fuels Volatility

 

U.S. stocks finished the trading session lower, but well off the day's the worst levels as volatility ramped up on heightened uncertainty inside the beltway. Afternoon reports suggesting that the Senate has enough votes to pass its tax bill were overshadowed by some uncertainty regarding the possible ramifications that the developing situation surrounding former NSA advisor Mike Flynn may have for the Trump administration. Treasury yields and the U.S. dollar traded lower as some upbeat reads on the manufacturing sector were seemingly brushed aside. Energy shares outperformed amid a rise in crude oil prices and gold gained ground.

The Dow Jones Industrial Average (DJIA) declined 41 points (0.2%) to 24,232, the S&P 500 Index decreased 5 points (0.2%) to 2,642, and the Nasdaq Composite lost 26 points (0.4%) to 6,848. In heavy volume, 972 million shares were traded on the NYSE and 2.3 billion shares changed hands on the Nasdaq. WTI crude oil gained $0.96 to $58.36 per barrel and wholesale gasoline ticked $0.01 higher to $1.74 per gallon. Elsewhere, the Bloomberg gold spot price increased $5.61 to $1,280.61 per ounce, and the Dollar Index—a comparison of the U.S. dollar to six major world currencies—was nearly 0.2% lower at 92.88. Markets were mixed for the week, as the DJIA rallied 2.9% and the S&P 500 Index advanced 1.5%, while the Nasdaq Composite declined 0.6%.

Ulta Beauty Inc. (ULTA $213) reported Q3 earnings-per-share (EPS) of $1.70, or $1.71 ex-items, versus the $1.66 FactSet estimate, as revenues rose 18.6% year-over-year (y/y) to $1.3 billion, roughly in line with forecasts. Q3 same-store sales rose 10.3% y/y, matching expectations. UTLA's gross margin came in south of expectations. The company issued Q4 EPS guidance that was below estimates, while its same-store sales outlook for the period had a midpoint that was just shy of forecasts. Shares closed solidly lower.

VMware Inc. (VMW $124) posted Q3 earnings of $1.07 per share, or $1.34 ex-items, compared to the projected $1.28, with revenues growing 11.0% y/y to $2.0 billion, roughly in line with forecasts. The cloud infrastructure and business mobility company issued Q4 guidance that exceeded expectations. Shares were nicely higher.

The major automakers reported November sales today, with General Motors Co's (GM $43) sales declining 2.9% y/y, compared to FactSet's projected 1.5% decrease. Ford Motor Co (F $13) reported a 6.7% rise in sales, versus the expected gain of 3.3%. Fiat Chrysler Automobiles NV's (FCAU $17) Chrysler sales fell 3.7%, compared to the expected 5.6% drop. GM and FCAU traded lower, while F finished higher.

Manufacturing activity continues to show solid expansion, tax reform uncertainty flares up

The Institute for Supply Management (ISM) Manufacturing Index (chart) for November declined to 58.2 from 58.7 in October, compared to the Bloomberg forecast calling for a dip to 58.3. New orders rose 0.6 points to 64.0 and production gained 2.9 points to 63.9, while employment dipped 0.1 points to 59.7 and prices declined 3.0 points to 65.5. Order backlog remained at 55.0 and new export orders decreased 0.5 points to 56.0. ISM said comments from respondents reflect expanding business conditions.

The final Markit U.S. Manufacturing PMI Index was revised to 53.9 for November from the preliminary reading of 53.8, versus expectations of 54.0, and below the 54.6 level posted in October. The release is independent and differs from ISM's manufacturing report, as it has less historic value and Markit weights its index components differently.

Although manufacturing slowed, these reports continue to suggest solid growth with readings above 50 denoting expansion for both indexes. Moreover, Schwab's Chief Investment Strategist Liz Ann Sonders notes that it’s time for optimism about a significant capex cycle unfolding as we look ahead to 2018, in her article, Takin Care of Business: Several Important Kickers for a Strong Capex Cycle, adding that tax reform—if we get it—would be an additional kicker.

Construction spending (chart) rose 1.4% month-over-month (m/m) in October, well above projections of a 0.5% increase, and following September's unrevised 0.3% increase. Residential spending was up 0.4% m/m, while non-residential spending jumped 2.1%.

Treasuries finished higher, with the yield on the 2-year note dipping 1 basis points (bp) to 1.77%, the yield on the 10-year note falling 5 bps to 2.36% and the 30-year bond rate dropping 7 bps to 2.76%.

The U.S. dollar reversed to the downside, along with Treasury yields following a two-day rally, after former National Security Advisor Flynn pleaded guilty for lying to the FBI and agreed to cooperate with the Special Counsel's Office. This caused a spike in volatility and fostered uncertainty about what this could mean for the Trump Presidency, with the Senate scrambling to find enough support to bring its tax bill to a final vote. The Senate delayed yesterday's final vote as a key area of compromise regarding deficit concerns hit a snag. The Senate spent much of the day in preliminary procedures to try to mend disagreements. Afternoon reports have suggested that the legislative body now has enough votes to pass its bill with a vote expected later in the day.

Schwab's Vice President of Legislative and Regulatory Affairs, Michael T. Townsend notes in his latest commentary, Tax Reform Bills Progress, but Many Hurdles Remain, if the bill passes the Senate, the House and Senate would need to convene a conference to negotiate and reconcile differences between the two bills to produce a single consensus bill. That bill would then need to be approved by both chambers before it could be sent to President Donald Trump for his signature.

Negotiations between the two chambers will likely be extremely challenging, given the differences between the two approaches. For investors, we still think it is too early to take any drastic action. If and when a tax bill passes, there will be time to review the details and amend your tax and financial plans accordingly. Regardless of the outcome of the tax bill, it’s always a good idea to meet with your tax and financial advisors before the end of the year to review your current financial situation and discuss your plans for the coming year.

Europe falls late in the day, Asia mixed

The European equity markets fell late in the session, with yesterday's delayed vote on tax reform in the U.S. stymieing recent optimism regarding progress being made to pass a bill and causing uncertainty to flare up. This was exacerbated former U.S. National Security Advisor Flynn pleading guilty for lying to the FBI and agreeing to cooperate with the Special Counsel's Office. Technology issues in the region extended the week's selloff, while auto-related issues saw some pressure. However, the energy sector was the lone group in positive territory amid a rally in crude oil prices on the heels of yesterday's OPEC agreement to extend its production cuts to the end of next year. An upbeat read on November eurozone manufacturing growth by Markit, which showed growth was revised to a higher acceleration from October's than initially estimated, was overshadowed.

The euro overcame early pressure as the U.S. dollar fell noticeably on the exacerbated U.S. political uncertainty, and the British pound came off the worst levels of the day but still modestly pared a recent rally. The pound found some strength this week amid signs that the deadlocked Brexit negotiations may be heading to the next stage. Bond yields in the region mostly saw solid pressure. Amid the flare-up in volatility, Schwab's Chief Global Investment Strategist Jeffrey Kleintop, CFA, notes in his article, Are Stocks too Expensive?, that although world stock market valuations are above average, similar valuations have produced double-digit gains over the following 12 months during the past 50 years. Jeff concludes that valuations support a globally diversified portfolio offering the best diversification benefits in 20 years.

Stocks in Asia finished mixed with the markets choppy following yesterday's delayed tax reform vote in the U.S. that appeared to cool some of the optimism that has led a sharp rally in the U.S. equity markets this week. Shares of Japanese companies advanced with the yen reversing a brief spike yesterday, while reports showed the nation's Q3 capital spending accelerated more than expected and household spending for October came in stronger than anticipated, while national October consumer price inflation rose in line with expectations. Mainland Chinese stocks finished flat and equities trading in Hong Kong declined on the heels of the flared-up U.S. tax reform uncertainty and a report from Caixin showing growth in the country's manufacturing output unexpectedly slowed, diverging from yesterday's government report that suggesting expansion surprisingly accelerated.

Australian securities gained ground with financials modestly paring yesterday's drop on the government's announcement that it will launch an inquiry into the sector, while energy issues rose following yesterday's OPEC production extension. Indian stocks fell on the heels of late-yesterday's report that showed Q3 GDP accelerated to a 6.3% y/y pace of growth, but slightly below the projected 6.4% expansion. South Korean equities finished flat in the wake of the recent selloff in the tech sector, yesterday's Bank of Korea rate hike, and today's stronger-than-expected Q3 GDP report. Even after this week's choppiness for the markets, they hold onto strong gains for the year fostered by the broadest economic growth in a decade, which is expected to continue in 2018 as discussed by Schwab's Jeffrey Kleintop, CFA, discusses in his article, 5 Reasons Investors Should Give Thanks.

Stocks higher on week as damage already done by the bulls

Despite the spike in volatility on Friday, most U.S. equity markets posted solid gains for the week, bolstered by signs the Senate's tax reform bill was finding enough support to gain momentum toward a final vote. Telecom and financial stocks led the way on the tax reform optimism, though a noticeable sector rotation came to the detriment of technology issues and the Nasdaq, which have led the markets' yearly rally and string of record highs. Economic optimism also helped boost the markets, with Consumer Confidence hitting a 17-year high, new home sales unexpectedly jumping to a decade high, Q3 GDP being revised higher to 3.3%, and culminating with the Fed's Beige Book showing business activity remained steady and noting a slight improvement in the outlook. Energy issues finished higher, while the highly-anticipated OPEC meeting delivered a production cut extension. Following Friday's volatility surge, the U.S. dollar finished little changed after showing mid-week signs of life and the Treasury yield curve gave back a brief bout of steepening.

This sets the stage for next week, in which the economic calendar will likely contend with continued scrutiny of tax reform, while delivering factory orders, the trade balance, the ISM non-Manufacturing Index, Q3 nonfarm productivity and unit labor costs, as well as the preliminary December University of Michigan Consumer Sentiment Index. However, the headlining report will likely be Friday's November nonfarm payroll report, with the Fed's December monetary policy meeting looming the following week and highly-expected to deliver a third rate hike of the year.

As noted in the latest Schwab Market Perspective: Incredible, Amazing…Unstop-a-bull?, the bull market continues to be undisturbed by a myriad of actual or potential negative events and momentum favors the bulls for the foreseeable future. However, elevated valuations and growing investor complacency pose risks that could lead to a long-awaited pullback and/or a pickup in volatility from today’s extremely low base.

International reports due out next week that deserve a mention include: Australia—Q3 GDP and the Reserve Bank of Australia's monetary policy decision. China—trade balance, Caixin's PMI Services Index and inflation statistics. India—the Reserve Bank of India's monetary policy decision. Japan—Q3 GDP. Eurozone—Markit's business activity reports, retail sales and Q3 GDP, along with German factory orders and trade balance. U.K.—industrial and manufacturing production, trade balance and the Bank of England's inflation target.