The steep correction of Q4 2018 feels like a distant memory, with stock markets soaring through the first half of this year. U.S. equities have eclipsed all-time highs set last year, reflecting renewed optimism that the record-setting economic expansion which began in 2009 will continue—even if at a slower rate.
Meanwhile, bond markets also rallied, with long-term interest rates sinking to around 2%. Long-term rates actually dipped below short-term rates on several brief occasions; this could speak to a more sinister undercurrent since, when sustained, an inverted yield curve is typically a reliable indicator of an impending recession 12-18 months hence. All said, many investors are wondering how to reconcile these two starkly different messages about the economic outlook.
The Federal Reserve Orchestrates a Dramatic Policy U-Turn
The answer to today’s mixed market signals lies (as it has so often over the past decade) in understanding the direction of monetary policy. Six months ago, the Federal Reserve (Fed) made overtures suggesting two interest rate increases were likely in 2019—the implication being that short-term rates would move up from just over 2% to close to 3%, on their way to a more “normal” level by year-end. Markets now anticipate the Fed will cut interest rates by as much as 1% this year. Such a dramatic and sudden U-turn in monetary policy is normally associated with the Fed adopting a decidedly grim view of the future.
There are two primary factors currently influencing the Fed’s stance. First, the labor market remains robust, with unemployment at very low levels; as a result, inflation has persistently stayed below the Fed’s 2% target. Second, trade tensions between the U.S. and China escalated dramatically during Q2, culminating in a temporary truce and tariff moratorium declared at the G-20 Summit in June. The uncertainty surrounding trade policy has weighed heavily on improved business optimism ignited by the 2017 Tax Cuts and Jobs Act. A sustained resurgence in business investment is an important fuel to the productivity growth necessary for the economic expansion to continue indefinitely without creating unwanted inflation.
In short, today’s resurgent stock market optimism is underwritten by belief the Fed will once again provide stimulus by lowering short-term rates. Proactive rate cuts bode well for the stock market in the near-term and, absent significant policy mistakes, there is reason to expect the expansion has room to run. Put differently, modest but consistent growth with low inflation could lead to an environment in which both stocks and bonds perform well, akin to what we saw in the late 1990s after the Fed lowered the Federal Funds rate under similar conditions.
Balentine’s discipline over several market cycles calls for us to reduce risk in portfolios in advance of an extended bear market when stocks become significantly overpriced relative to bonds, just as they were in 2000 and 2007. Although the outlook for further economic growth in 2019 is dimming and corporate earnings expectations are ratcheting lower, stock valuations relative to bonds are improved compared to the end of last year because interest rates have fallen so much. This confirms our belief that preconditions for a major stock market top are not yet in sight. Other hallmarks of an imminent recession, such as tighter credit conditions and weakness in commodity markets, are not prevalent, either.
Against this backdrop, in late April, our indicators confirmed the pullback stock markets experienced in 2018 was over. As a result, we added exposure to stocks across all strategies, eliminating the modest underweight established in early December 2018.
After such a strong start to the year, it would not be surprising if further stock market gains do not come as easily and without volatility. The U.S. and China still have a way to go toward a permanent resolution over trade policy, and the 2020 political cycle is taking shape with a number of leading candidates adopting unusually extreme positions on the economy. It is clearly in the interest of the Trump administration to ride the tailwinds of a strong economy and stock market into the election. Given widespread angst over the confusing signals stock and bond markets are sending, perhaps an outcome for which investors are least prepared is a sooner-than-expected resolution on the trade front and a pickup in the economy boosted further by lower interest rates. If this occurs, addition stock market gains and accompanying euphoria and valuation excess—which eventually kill bull markets—could be closer than they appear.