The Federal Reserve (Fed) lowered rates on July 31. In anticipation, investors bid up prices before the meeting, peaking at 3,028 on July 26.
The market did not like that Fed Chairman Jerome Powell referred to the 25 basis points cut as a “mid-cycle adjustment,” hinting that more cuts are not guaranteed.
Bond prices suggested the Fed was leaving short-term rates too high relative to medium-term and longer-term market rates, which would eventually drive the economy into recession.
As August began, the stock market, already reeling from the Fed’s body blow the day before, received an upper cut from President Trump in the form of a tweet announcing further escalation to the trade war with China. Stocks’ downdraft correlated directly with Trump’s tweet at 1:26 PM on August 1, as seen in the following chart.
Other August Occurrences
U.S. headline jobs data was mixed. Jobs still exhibited growth, but not as strong as expected. The data was not weak enough to justify a market-desired 50 basis points interest rate cut, but it was also not strong enough to allay concerns of a looming slowdown.
The yield curve inverted, with the 5-year yield marking the trough rate. This, of course, led to speculation in the financial media and from economic pundits that a near-term recession is all but certain.
International markets reflected concerns, with equity prices declining and bond prices rising in the face of much uncertainty. Among the causes of agita:
Further escalation in the U.S./China trade war
The effect of low interest rates and low oil prices on banks and energy companies, respectively
Less dovish Fed action than desired
U.S. Treasury yield curve inversions
Potential U.S. tariffs on the E.U., most specifically autos
Unrest in Hong Kong
Trade tensions between Japan and South Korea
Apparent slowdown in the European economy
Persistently high Italian bond yields
What We Think
Under the surface, jobs numbers and wages remain strong. Slowdown concerns are nowhere to be found in unemployment claims, especially at the blue-collar level. Wage growth is more robust than we have seen in many years. Importantly, the workforce participation rate continues to increase as the civilian labor force grows. We think this may be the main driver behind the Fed’s hesitation to cut rates more aggressively.
We do not believe the yield curve is signaling recession at this point. We are generally not a subscriber to the “this time is different” theory; however, we do believe there are unique factors driving the recent yield curve inversion:
Inflation remains extremely tame despite pronouncements that tariffs will have an inflationary effect on consumer prices.
Much of the move in yields is on the short end of the curve. The 5Y-10Y durations are partly a function of overseas declines in yields and a flight to safety in the U.S. The declines overseas are very much a function of economic concerns, as we believe Europe is likely already in recession, having suffered consequences of the trade war more than the U.S. As a data point, the recent plunge in industrial orders in Germany, Europe’s growth engine, points to major stress in Europe.
Lastly, and perhaps most importantly, it is not likely that the yield curve inversion, which has become a highly scrutinized indicator, will be as reliable going forward. In years past, when the yield curve was not as widely followed, natural movements would have resulting consequences. But now, given the increased focus, one could argue yields are partly a function of self-fulfilling prophecy, which lessens the efficacy of the indicator.
Although trade war headlines tend to be bleak, the news is already largely priced into markets. In fact, Chinese stocks (excluding Hong Kong) are at five-month highs, though their performance remains sharply down relative to U.S. stocks.
What We're Watching
The Fed meeting on September 16-17. We expect a 25 basis points cut; while a 50 basis points cut is not completely off the table, we would be surprised if it were to occur. More important than the cut will be the associated language in the Fed statement and its policy outlook.
We expect seasonal volatility in the equity markets as the fourth quarter gets underway.
What's in Store for Capital Markets?
The S&P 500 spent August bouncing between 2,822 and 2,945. The index finally broke out of that range in early September, and we now need to see if the 2,945 level can hold as support. Although the market has exhibited strength in the first half of September, uncertainty will likely keep a lid on potential gains, even if we surpass the index’s recent high.
Longer-term, investor sentiment is still extremely negative as judged by equity positioning and put/call ratios. This “wall of worry,” combined with compelling valuations, should be a tailwind for equity prices once seasonality runs its course in late October.
Geopolitical and economic concerns look to be priced in—hence, the volatility and equity performance relative to bonds. Equities remain inexpensive both in absolute and relative terms to bonds. In fact, our primary valuation indicators suggest the market has not been this inexpensive since it bottomed from a consolidation in 2015-2016, which set the stage for a strong bull run over the subsequent two years.
History demonstrates the longer the consolidation, the stronger the move after breaking out (as shown below). Equities have been consolidating since January 2018, and we believe patience will be rewarded with strong performance after the market finishes its right-sizing process.
As fear slowly abates, we expect the equity bull market to enter its next leg, which is affirmed by the momentum and relative value signals we see in our investment models.
We expect interest rates to rise somewhat from their recent lows, as August’s rate declines (and rate declines over the past nine months) have far exceed expectations. That said, global central banks re-engaging in monetary stimulus will likely keep a lid on rate appreciation. Thus, we do not expect rates to approach their November 2018 highs anytime soon.