Caution: China Worries, Morgan Stanley Results Could Pose Challenge

(Thursday Market Open) After an impressive start to the week, markets appear to face some tough sledding Thursday as investors eye disappointing earnings from Morgan Stanley (NYSE:MS) lack of progress on China trade, and no end in sight to the U.S. government shutdown.

While focus in the early going might be on MS, the market was already down before that as new clouds appeared on the China trade horizon. A Republican senator said President Trump is considering new auto tariffs, and the Chinese government put out a statement critical of U.S. pressure on the China technology firm Huawei (SZ:002502).

Going into Thursday, it seemed fair to say banks were having a pretty decent earnings season, and many did. However, MS ran into trouble late in Q4 as its wealth management and fixed income trading businesses sagged, and the company missed third-party consensus estimates for both revenue and earnings per share. The stock fell more than 5% at one point in pre-market trading before clawing back a bit, and other major bank shares took a hit as well. However, the rest of the market seemed relatively unaffected by the MS news.

Given the fact that every other major bank said they were having trouble with trading, it shouldn’t seem too surprising that MS—the firm that’s taken the mantle on the trading business in recent quarters and relies more on trading than many of its competitors— should have some hiccups. We’ll see today if MS can follow the pattern other bank stocks established earlier this week of opening lower and coming back later.

Looking at the raw numbers, MS reported earnings of $0.80 a share on revenue of $8.5 billion. That was well below Wall Street analysts’ expectations for 0.92 and $9.43 billion. The bank said softness in the weeks after Thanksgiving helped contribute to the disappointing results, with the company’s CFO saying the Q4 ended “messily.”

Seeking better news? Regional bank shares showed some spark in pre-market trading after some of the major banks in that sector reported earnings results exceeding Wall Street expectations. Also, some investors apparently expect positive news from Netflix (NASDAQ:NFLX) after the close, at least judging from the way that stock has catapulted higher since Christmas. Its shares have risen 50% over that time.

For the quarter at hand, NFLX is expected to report EPS of $0.24, down from $0.41 in the prior-year period, on revenue of $4.21 billion, according to third-party consensus analyst estimates. Revenue is projected to grow 28% year-over-year.

As has been the case in recent reports, subscriber additions, content spending and cash flow, and growing competition are likely to be some of the main areas analysts and investors hone in on.

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Before MS earnings hit the market with a thud early Thursday, Goldman Sachs (NYSE:GS) posted its best day in a decade on Wednesday. It wasn’t just because the company beat third-party earnings and revenue projections. It was also because GS seems to be successfully putting into place a lot of the things it’s been talking about for the last year and a half, namely on the investment banking side.

Traditionally, GS has been known for its trading, but it’s reorganized recently away from trading and more into investment banking. That strategy appears to be paying off, with the company’s investment banking business revenue exceeding expectations in Q4. While GS saw a rise in expenses, that actually might have gotten a positive view from the Street. The thinking might be that to do investment banking, you need to hire. Advertising costs went up, which could be another sign of the transition.

GS was long considered a premier trading company, but trading might not need to be their their bread and butter. They seem to have other ways of making money.

Bank of America (NYSE:BAC) was the other outstanding bank performer Wednesday after quarterly profit tripled. In all, BAC rose 7% and GS rose 10%, putting financials in the leader’s seat among all sectors by a wide margin. Solid loan numbers and growth in equity trading appear to be overshadowing sluggish fixed income trading for many firms. Financials rose more than 2% for the day, and are up more than 4% since the start of January.

According to some veteran analysts, it’s very difficult for the overall market to get off the canvas and stage any kind of solid rally without participation by the banks, in part because banks are the companies that finance the rest of the economy. The market did rally through parts of 2018 without much help from financials, but that might have been the exception, not the rule. Financials being up so far this year is arguably an important development for the market.

One caveat is that some of the exuberance may have been linked to short covering in a battered sector. On the other hand, it could be a sign that people are feeling more comfortable about putting money to work in some beaten-down groups. If the financial sector rally lasts, then the second of those two thoughts would probably win out.

The strength in financials comes despite a lot of dovish talk from Fed speakers over the last week. Most of the ones doing the talking seem to be reading from the same hymnal lately, and the operative words arguably have been “pause” and “patience.” Those were some of the takeaways from speeches this week by Federal Reserve Bank of Dallas President Robert Kaplan and Kansas City Fed President Esther George. According to Kaplan, it would be “wise to be patient” for the Fed, he told reporters. He said the Fed should be thinking in terms of “months, not weeks.”

George, meanwhile, said, “A pause in the normalization process would give us time to assess.” That might have seemed like a bit of a surprise coming from George, who some analysts describe as typically rather hawkish.

The Fed’s recent vibe might give the market a chance to calm down after the interest rate scare last fall when the 10-year Treasury yield jumped above 3.2%. It’s now trading around 2.72%. There’s also talk that the Fed might not just pause hikes, but also slow its balance sheet reduction. Both of these strategies would conceivably loosen up the money supply a bit and help stimulate the economy.

With that in mind, we turn abroad, where China announced several measures this week to boost its economy, including tax cuts, the injection of liquidity into the markets, and a lowering of the reserve requirement. China’s moves, which come after some sluggish economic data, might also be taken in the context of its trade battle with the U.S. Not much news has appeared on that front lately, but the stimulus might remove some fear from global markets.

Back on Wall Street, airlines got some attention Wednesday after United Continental (NASDAQ:UAL) easily exceeded third-party earnings per share estimates. One telling thing about UAL’s analyst call was the CEO saying the company isn’t too concerned about the impact of the government shutdown. Some airlines might be more affected than others by the standoff in D.C., depending on how much exposure they have to government contracts.

Another surprise from UAL was the company not seeing fuel costs being a big risk going forward. That’s a huge expense for airlines, so to hear confidence on this metric from a leading company in the space could help boost morale around an industry where some stocks have been getting grounded lately.

Speaking of “grounded,” that word might be used to describe the retail sector Wednesday. Disappointing holiday sales data from Nordstrom (NYSE:JWN) followed similar weak news from Macy’s (M) last week. Consumer discretionary became one of the few sectors to end up in the red for the day. While some of the holiday weakness is probably getting built into the shares, it doesn’t necessarily set up a lot of optimism ahead of retail earnings season next month. It also raises questions about whether some of the higher-end retailers like Tapestry (NYSE:TPR) and Tiffany (NYSE:TIF) might have a bit to be worried about going forward. Shares of both fell Wednesday.

Even amid all the earnings, there’s some data that might be worth monitoring toward the end of this week, namely industrial production and University of Michigan Sentiment, both due early Friday. With retailers reporting struggles during the holiday shopping season, it might be interesting to see if consumers were starting to feel the impact from slowing markets at the time, and whether that played into their shopping decisions. Industrial production is arguably important because it can be pretty sensitive at times to consumer demand.

One thing that might help buffer sentiment is low prices at the pump. Crude is up about 25% from last month’s lows, but still hasn’t recovered all that much from the major haircut it took since early October, and gasoline around the country costs an average of $2.24 a gallon according to AAA. Heavy U.S. supplies may helping keep the lid on rallies. U.S. crude supplies fell modestly last week, but gasoline stockpiles saw a heavy rise, the U.S. government said Wednesday. Production of nearly 12 million barrels a day is at a record high.