29 July 2019
U.S. Stock Indexes Reached New Highs but Recent Data Shows Reasons for Concern
U.S. stock indexes recently moved to new record highs; however, they are only slightly above January 2018 levels. Investors have been buoyed by the belief that the Federal Reserve will start cutting rates later this month, while also receiving a tailwind from the perceived ratcheting down of trade tensions with China. Investor sentiment has reached the extreme optimism zone—a contrarian indicator—according to the Ned Davis Research Crowd Sentiment Poll, suggesting some caution is warranted in the near term. We are also concerned that investors seem to be ignoring some budding risks. There is the potential that the Fed doesn’t deliver the number of cuts the market is currently expecting over the remainder of the year, with fed funds futures currently pricing in a greater than 50% chance of three cuts by the end of the year. We are also skeptical about the actual impact a rate cut may have. As Chairman Powell noted many times in his testimony before Congress, today’s economic “uncertainty” is due largely to trade; it is not a function of rates being too high. As such, we’re skeptical that lower rates are the elixir to what ails the economy—at least not enough to offset the trade-related uncertainty.
Are lower rates really going to help?
While the meeting between China and the United States at the recent G20 summit resulted in a temporary cooling of tensions, it did nothing to reduce the currently imposed tariffs. Both sides have indicated there is still much hard work remaining to complete for a deal; while there was no deadline announced. It’s difficult to envision a reigniting of corporate animal spirits absent a trade deal, which suggests recent weakness in business capital spending is likely to persist. Adding to the trade-related uncertainty, the United States is also at loggerheads with the Eurozone and India; while passage of the USMCA remains bogged down.
U.S. manufacturing has weakened this year, especially new orders; approaching levels typically associated with recessions. For now, relative strength in services is a positive offset, but if manufacturing continues to weaken—following weak global manufacturing trends, it would likely bleed into services. We’ve also seen trade uncertainty impact small business confidence and, for the first time, potentially consumer confidence.
And consumer concern seems to be rising
Lately the stock market seems to be viewing good news as bad as it could hurt the chance of a Fed rate cut. June’s labor report showed a rebound from May’s weakness with 224k jobs created—greeted by the selling of stocks by investors. Illustrating this trend more broadly, since early 2018, stocks and economic surprises have moved into negative correlation territory; in stark contrast to the nearly-perfect positive correlation of the first 16 months of the Fed’s rate tightening cycle.
To those cheering negative economic news, be careful what you hope for. An economic decline to the point that the Fed has to cut multiple times would likely be recessionary and not a positive backdrop for stocks.
Earnings could provide a boost
Second quarter earnings season is underway and estimates coming into the quarter were relatively downbeat, with a slight negative year-over-year change anticipated according to Refinitiv. Now that companies have begun reporting, that estimate has moved back into slight positive territory.
The stock markets’ optimism in the first half of the year over the potential for rate cuts in the second half of the year may fade if those cuts further undermine earnings growth, which is already weak. In the past, rate cuts took place near the peak in the earnings cycle for global companies—in part due to their impact on the financial sector. Since financial conditions are not currently acting as a drag on growth, as mentioned above central bank actions may do little to spur growth that could offset the drag on financial sector earnings. Stocks may struggle to sustain this year’s rise in valuations if earnings fail to rebound as analysts currently predict.
Fed decision coming
While earnings will gain much investor attention, eyes are also keenly focused on the two-day Federal Open Market Committee (FOMC) meeting that concludes on July 31st. The market is pricing in close to a 100% chance of at least a 25bps cut, with a roughly 43% chance for 50bps. Attention will be closely paid to forward-looking comments in the FOMC statement and subsequent press conference as to the chances for further cuts. We believe there is a chance of a disappointment for investors hoping for an aggressive easing program. The labor market still looks healthy, which is half of the Fed’s “dual mandate;” with unemployment claims historically-low.
Stocks recently hit new record highs but sentiment is elevated and the possibility of disappointments may be rising. Lower rates could be an offset to ongoing trade tensions, but lower rates are unlikely to mean a trade deal is more likely. We continue to suggest investors remain at their long-term strategic equity allocations, using discipline around diversification and rebalancing.
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About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research