“There are two things that can disrupt business in this country. One is war, and the other is a meeting of the Federal Reserve Bank.”
Will Rogers, one of America’s favorite humorists suggested nearly 100 years ago that war and the Federal Reserve were primary levers behind the U.S. business cycle. Fast forward to today and only the context has changed. Global central banks have hit the “easy button” to combat slow growth and deflation risks while trade wars between the U.S. and China persist. Markets have responded to easy central bank policy with easy gains. The election season has begun, Presidents Trump and Xi are meeting at the G20 meeting in Osaka, Japan, and global markets continue to seek a fundamental catalyst to break out of their 18-month trading range. Stock, bond and balanced portfolios have surpassed expectations so far in 2019 so our attention soon shifts to the remainder of 2019 and 2020.
Fed Shifts from Pause to Pivot
In our February edition we said: “Our base case is for a pause until at least June with rates already at the lower end of the Fed’s neutral range.” In our March edition we said: “The Fed wants to avoid outright deflation at all costs as that would shift the U.S. economy from its current stall speed into recession.”
Last week’s FOMC meeting saw the Fed strike a decidedly dovish stance signaling potential rate cuts as early as the July 31 meeting while simultaneously lowering their forward rate views. Persistently low and falling inflation below the Fed’s 2% target has now created an argument for rate cuts sooner rather than later. This is supported by the chart below created from data in the CME FedWatch tool, which tracks Fed Funds futures. It suggests:
- 57% odds of a .25% rate cut in July
- 85% odds of a .50% cut by September
- 54% odds of a .75% cut by October
In other words, the futures market is telling the Fed that they are .75% behind the curve and need to cut rates now.
Takeaway: The FOMC is walking a fine line between the short-term pain of market corrections caused by inaction and the long-term dilemma of exhausting future monetary policy by emptying their tool box. A pause at the July 31st meeting could cause downside risk to risk assets while a .5% cut would please risk assets. Other global central banks (Europe, Japan and UK) have positioned themselves for future easing as well so the U.S. is not alone. A primary long-term concern for renewed central bank easing is the unknown consequences of uncharted waters.
Weak business confidence has begun to trickle over into weakening consumer confidence so our base case today is a .25% rate cut at the July 31st meeting and an end to the Fed’s balance sheet reduction before their previously announced Sept. 30th deadline. This should support market sentiment.
Stages of Trade: War/Truce/Deal
Current talks between the U.S. and China negotiators center on an agreement to continue discussions rather than an actual deal. After recent escalations beginning on May 10th what we are seeing now likely qualifies as a trade war impacting both economic and profit growth. Our best-case scenario for this week’s meeting between Trump and Xi would be for a trade truce, which we classify as an agreement to de-escalate while talks continue. A trade deal would be the best possible outcome but has become elusive as national security concerns simmer with neither side showing signs of backing down. Such a deal would likely include both a commitment to de-escalate and a plan to peel back existing tariffs. This increasingly looks like a late 2019 or even early 2020 possibility.
China likely feels greater economic urgency as supply chains slowly shift away from China while the U.S. likely feels greater political urgency with 2020 looming large. To get a deal done, neither side will blink but both have to make some concessions to prevent consequential spillover. Further deterioration in confidence, which creates economic drag and/or deflation, remains the greatest near-term risk.
Election 2020, Let the Games Begin
The Democratic candidate presidential debates have begun. In a mirror image of the Republican Party in 2016, there are over 20 candidates. We expect a similar result in 2020 as lesser candidates thin out while others slug it out to win the nomination. The chart below reflects predebate poll numbers through Sunday, June 23rd, with data sourced from Real Clear Politics polls. It is far too early for predictions and interestingly, there are 13 candidates polling below 1% who combine for 5.3% of the vote, according to a wide variety of polls. Many of these folks will not be around for the July debates.
Takeaway: Markets don’t react to politics, they react to policy. Until clear policy initiatives begin to emerge from leading candidates including President Trump, market reaction should remain muted. As policies emerge and polls take a sharper focus, markets will take notice early in 2020. Polls are inherently unreliable at this stage of the game despite their entertainment value. Investors would be wise to ignore headline turmoil regarding their investment decisions at such an early stage.
Q2 Earnings Season
Second-quarter earnings season kicks off in two weeks. We expect a repeat of Q1 where analysts downgraded estimates into earnings season out of an abundance of caution only to see modestly positive surprises. Prolonged trade-related uncertainty has weakened business sentiment, but it has also weakened analyst sentiment as reflected in the chart below.
Since March 31st, Q2, Q3, 2019 and 2020 analyst earnings estimates have all shifted lower. Even modest outperformance for the next two quarters will leave S&P 500 earnings hugging a flat growth line through Q3. With 2019 earnings increasingly dependent on a Q4 rebound, we will be watching those expectations closely.
Takeaway: Earnings are more sensitive to economic growth than any other variable. This highlights the importance for continued low unemployment, contained disinflation and a restart for business confidence.
Markets have rewarded most investors so far in 2019 despite some of the concerns we have discussed. Markets are a discounting mechanism that have anticipated late-year economic growth and are optimistic for conflict resolution and global economic resynchronization.
Stocks: Global equity indices, led by the U.S., have rewarded shareholders in 2019 with double-digit returns as shown in the chart below. Growth continues to outpace value as investors flock to growth stocks as a proxy substitute for anemic economic growth. We expect this to continue in the near term but seek evidence of a pick-up in global economic growth before value stocks gain at the expense of more expensive growth stocks. This is a trend we will watch closely as the rest of the year unfolds.
International stocks have modestly trailed U.S. equities in 2019, which supports our strategic allocation to overweight U.S. equities versus global benchmarks. Global benchmark allocations approximate a U.S. allocation of 54% whereas our strategic overweight to U.S. equities is closer to 70%. This has benefitted performance versus global benchmarks. Currencies have not had a material impact on international stock performance for the first half of 2019, but it is our belief that second half dollar weakness could provide extra lift to international stock returns.
Bonds: Recent bond yields have declined precipitously across the yield curve providing better-than-expected total returns as shown in the chart above. We will likely remain in a narrow range that hovers near a less than expected 2% yield for U.S. 10-year notes. High-yield bonds remain attractive despite tight credit spreads with continued low default rates. We will monitor this for signs of deterioration in the event of persistent economic weakness. Municipal bonds remain in high demand but low supply is causing their index returns for 2019 to exceed 5%. We do not anticipate a near-term back up in interest rates and continue to think new money is best placed in the short maturity area of the yield curve to generate near-equivalent interest income without subjecting investors to the risks of future interest rate increases.
- We see Q2 GDP growth of 2-2.5% versus a noisy Q1 result of 3.1%.
- The Fed’s easy language from the June meeting is likely to translate into a July rate cut.
- A trade truce (de-escalation) is more likely than a trade deal in the near-term.
- 2020 election rhetoric will escalate with no near-term economic ramifications.
- 2019 earnings are expected to be flat through Q3 with Q4 coming under closer scrutiny soon.
- Attractive global equity returns in 2019 have been driven by PE multiple expansion but are in search of a catalyst to break out of the 18-month trading range.
- Bonds will continue to provide ongoing portfolio ballast despite the recent and unexpected plunge in interest rates.
- We will provide our second-half 2019 Outlook in mid-July.
We wish all clients, friends, associates and their families a safe and Happy Fourth of July. It’s a great time to remember and celebrate the freedom and opportunity we enjoy in this great country. Thank you!
Jeff Terrell, CFA Chief Wealth Market Strategist
BB&T Wealth Portfolio Management Team
Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors
The Morningstar indexes are unmanaged, weighted indexes of stocks and bonds providing a broad indicator of price movements. Individual investors cannot directly purchase an index.
The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.