As we move into quarterly earnings season here in the U.S., the economic backdrop is littered with mixed signals. On the positive side of the ledger, we are seeing a healthy consumer buoyed by steady employment and improving wages. Stable inflation and an accommodating Federal Reserve also help. On the negative side of the equation, there is lingering political uncertainty due to what feels like never-ending trade tensions. Corporate confidence is wavering, limiting capital expenditures and earnings expectations for the most recent quarter are muted.
There has been a reversal of sentiment among Federal Reserve Governors, many of whom said in late March and April that there was no case for a rate cut. Now, the market is pricing in at least one rate cut in the foreseeable future, as Chairman Powell provided further clarity about the Fed’s stance in recent testimony. Despite steady job growth figures in June, he suggested the possibility of a rate cut taking place at the late July meeting, citing weakening global economic and inflation growth as the primary factors driving decision-making.
Tracking Fed expectations, short-term rates were relatively stable through the end of April but have sharply fallen in recent weeks as the likelihood of a rate cut increases. Longer-term yields are moving downward due to a combination of factors: the search for safe assets is boosting demand for bonds, driving up prices and lowering yields; lower growth and inflation expectations are also increasing demand; and finally, expectations of lower rates in the future make it more attractive to lock in higher long-term rates. Spreads on corporate debt are above their decade lows (at the beginning of 2018) but remain at shallow levels consistent with economic expansion and low default rates.
Uncertainty around global trade negotiations has been the other major driver of market movements. In mid-May, the U.S. stated it would delay its decision on imposing auto tariffs on the European Union and Japan up to six months. While providing temporary market relief, the issue is expected to resurface in the next few months.
Similarly, the U.S. threatened 5% tariffs on Mexico in early June as a strong negotiating tactic in pushing Mexico to address rising migration issues. While the tariffs were called off again and resulted in overall favorable market reaction, mounting selling pressure did drive down prices.
Concerning China, markets responded positively to the meeting between President Trump and President Xi at the G-20 meeting in Osaka at the end of June. The U.S. offered to reduce pressure on Chinese telecom giant Huawei, and China agreed to increase purchases of agricultural goods. There are still many unresolved issues, however, and negotiations will likely continue. Meanwhile, several U.S. companies have already started moving production facilities outside of China, and Huawei recently announced extensive layoffs—in the hundreds—at its U.S. operations.
Equities have continued to maintain a solid run year-to-date, erasing last year’s steep losses and notching new record highs. The S&P 500 was up 18.3% through the end of the second quarter this year. Small-cap stocks have generated strong returns as well but have notably lagged larger companies. The Russell 2000 small-cap index gained 17.0% through the end of Q2. Numerous variables have been supporting stocks this year, including the prospect for lower interest rates, growth and employment data, and advancements in trade negotiations. Perhaps lost in the euphoria of the progress is the fact that the U.S. still imposes 25% tariffs on about $250B in Chinese imports.
The Federal Reserve has clearly stated that they are “data-dependent” when deciding how to handle interest rates. With that in mind, what are the drivers that would impact the Fed’s decision to increase or decrease rates? In our opinion, an unanticipated move upwards in inflation would increase the chances of the Fed raising rates as well as the unemployment rate staying in a range near historical lows of 3.5-3.7%. An unexpected pickup in economic growth would also increase the probability of the Fed raising rates in the near-term.
Conversely, for an interest rate cut to occur, we would need to continue to see slowing growth in the U.S. economy as well as continued low inflation. Mounting trade tensions that would result in increased tariffs could also lead to the Fed easing rates. Growth does appear to be slowing after “breakout year” 2018; however, it is merely sliding back to the 2.0-2.5% range. The growth rate between 2009-17 hovered around the 2% range as well, and as such, is not a significant concern for us. Growth dropping to around 1.5% would be a yellow flag and give some cause for concern.