An expanding economy, falling bond yields, and a Fed that is poised to cut interest rates have pushed the Dow, NASDAQ, and S&P 500 Index to new highs, countering headwinds from trade and a slowing global economy. Year-to-date, returns have been impressive.
Yet, it’s not all sunshine and roses. Small caps are up but have lagged the large-cap indexes, creating anxieties in some corners that today’s rally lacks a broad base and may not be sustainable. Still, let’s not discount the importance of the new highs in key indexes.
Headwinds and risks never completely abate. When the perception arises that hurdles no longer exist, perfection gets priced into stocks and small disappointments can lead to significant pullbacks. We saw that situation arise in early 2018.
1. Powell’s about-face on interest rates
- The Fed’s 180-degree pivot, which began in January, is just about complete.
- Gone is talk of “gradual rate hikes.”
- Fed Chief Powell’s testimony last week before two Congressional committees green-lighted an expected rate cut at the July 30–31 meeting.
- Fed funds futures put odds of a 25bp cut in rates at 66% and place a 50bp cut at 34% (as of July 17).
- Credit dovish testimony from Powell last week for talk of a more aggressive stance.
- Is 50bp at the July meeting too aggressive? Seven of 17 Fed officials see a total reduction of 50bp by year end, according to the Fed’s dot plot. No one projected more than 50bp.
- Powell incessantly harped on trade uncertainties and the possible impact on business confidence and capex outlays.
- No longer does the Fed appear to be data-dependent. Instead, its emphasis on uncertainty appears to be paving the way for an easier monetary policy.
- The big unknown: Will falling business confidence significantly impact capital spending, which in turn slows hiring and dampens consumer confidence and consumer spending?
- There isn’t a modern historical precedent to model the impact of a trade war on the economy.
- Low inflation is giving Powell and the Fed the cover to ease inflation.
- Inflation has remained surprisingly low for an economy that sports a jobless rate under 4%.
- The Phillips curve, which suggests there is a tradeoff between inflation and unemployment, is broken.
- Using either the core CPI or the core PCE Price Index, inflation has hovered near or below 2% since 2012.
- Using the core CPI, the Fed has achieved its target of 2% inflation.
- But the Fed’s preferred inflation gauge is the PCE Price Index, not the CPI.
- The core PCE has averaged 1.64% since 2012 and has rarely exceeded 2%.
Figure 1: Core Inflation-Percent Change vs. 1 Year Ago
Will inflation permanently hold at lower levels?
- The core PCE has slowed over four distinct periods since 2012.
- Might we accelerate again to near 2%, only to fall back?
Inflation and Fed intentions
Powell suggested low inflation is a rising concern at the Fed in this remark during the Q&A session with senators.
“You don’t want to get behind the curve and let inflation drop well below 2%. Because what happens is that you get into this unhealthy dynamic potentially where lower expected inflation gets baked into interest rates, which means lower interest rates, which means less room for the central bank to react and that becomes a self-reinforcing thing.
We’ve seen it in Japan and we’re now seeing it in Europe. That’s why we think it is so important that we defend our 2% inflation goal here in the U.S.”
- A subtle but significant shift—Powell is no longer talking “transitory” as he was just a couple of months ago.
Is the Fed succumbing to White House pressure to cut rates?
- Publicly, Powell has asserted the Fed’s independence. How meetings play out in private may be another matter.
- Economic growth has moderated, and the bond market has gotten ahead of the Fed, but growth has yet to falter.
- Interest rates are already low, but the Fed is hoping to spark a rise in business confidence by tapping the monetary gas pedal.
- Fed officials must anticipate trends, as monetary policy works with a lag.
2. Monetary ammunition
- The fed funds rate is 2.25%–2.50%.
- Table 1 highlights the rate cut cycles during prior recessions.
- While I’ve included recessions going back to 1957 (excluding the short 1980 recession), let’s focus on the last three recessions.
- Rates were much higher heading into the 1990, 2001, 2008 downturns.
- There’s not much room to cut in the event growth falters.
- The Fed lacks the conventional firepower to deal with an economic downturn.
3. The tale of two economies
- Manufacturing is soft, while the service sector/consumer spending is holding up.
- We see it in the ISM Manufacturing Index, the regional Fed manufacturing surveys, and industrial production (though June’s manufacturing output surpassed expectations).
- Services and consumer spending have proved to be more resilient, as they are less dependent on the global economy.
- Retails sales have posted modest to strong gains in four of the last five months.
- Three-month annualized retail sales minus autos and gas stations have been strong—see Figure 2 below.
Figure 2: Consumers Ignore Trade Headlines
- Consumers don’t seem to be paying much attention to trade headlines.
- Job growth has moderated versus a year ago, but businesses continue to hire.
- Average monthly increase in non-farm payrolls has been a respectable 172,000 in the first half of the year versus 235,000 a year ago.
- A low level of jobless claims suggests employers are reluctant to lose workers amid an expanding economy.
- The Fed’s most recent Beige Book, which summarized the anecdotal activity between mid-May and early July, noted, “The outlook generally was positive for the coming months, with expectations of continued modest growth, despite widespread concerns about the possible negative impact of trade-related uncertainty.”
4. A peek ahead
I. GDP expected to slow in Q2
- The Atlanta Fed’s GDPNow model suggests Q2 expanded at a 1.6% annualized pace, down from 3.1% in Q1.
- One-time factors overstated Q1 strength.
- Quarterly numbers can be lumpy. Averaging the periods will provide a more reliable take on economic growth.
Figure 3: Lumbering Ahead
- Consumer spending is projected to rise a strong 4.2% in Q2, offset by sluggish manufacturing and business spending.
- It’s a big rebound from 0.9% in Q1.
- The soft patch in 2019 has not been as pronounced as the slowdown in 2015–16, according to most economic reports.
II. All eyes on earnings
- The pattern we’ve seen through much of the expansion is reasserting itself.
- Analysts reduce estimates amid conservative guidance and companies top expectations.
- Today’s culprits—the uptick in the dollar, weaker margins, and the global slowdown.
- It’s early but 80% of firms have beaten on the bottom line.
- Until a recession emerges, the pattern seems likely to continue.
Source: Charles Sherry, MSc, July 19, 2019