With the start of Monday comes an extension of what was quite the eventful week for markets. China’s announcement that it will be devaluing its currency comes after what was one of the busier weeks of the quarter for corporate earnings, important economic data releases, the highly anticipated rate cut from the Federal Reserve, and of course several influential tweets from the President. At the end of it all, the S&P 500 was down over 3% and Monday has opened with what looks to be the market’s worst day since the middle of May; two weeks removed from hitting all-time highs. Historically speaking, August and September have been the worst performing months for the stock market on average. While theories behind this range from lower trading volumes due to families on vacation to mutual funds beginning their process of tax loss harvesting for the year, there isn’t any consensus on the reason for this bizarre historical trend. We’re not one for engaging in superstition here, but with the first week of the dreaded month of August starting out and the abundance of eventful news and data delivered, there seems no better time to make sense of the details in order to assess the market status quo.
On Wednesday, the Federal Reserve announced a remarkable shift in monetary policy. For the first time in over a decade, the Fed announced that they would be cutting the federal funds rate. Historically, evidence suggests that in the near term, the 0.25% cut in interest rates would presumably act as a tailwind freeing up stock valuations to run higher. However, we live in a news saturated environment where traders, analysts, and media pundits scour every statement made by members of the Fed in order to parse any trace of underlying meaning. There exists the possibility that the market is so “efficient” (or “inefficient” depending on one’s perspective) that stocks are pricing not only the 0.25% rate cut received on Wednesday but also future rate cuts in September, October, and/or December. In his press conference, Fed Chair Jerome Powell seemed to be positioning the rate cut as a mid-cycle adjustment; he stopped short of guaranteeing that this was part of a series of cuts that would further loosen monetary policy. The institutional algorithms and traders monitoring every word of his statement immediately moved the market downward upon this implication. The more interesting aspect of these rate cuts is the broader, mostly unprecedented shift it signifies from a historical context. In the midst of the longest economic expansion this nation has ever seen, a time defined by a record high in the stock market, continued (albeit slowing) GDP growth, and record low unemployment, the Fed has made the decision to cut already relatively low interest rates. Interest rate cuts, the administration’s earlier tax cuts, and government spending are all policy tools that are typically used to combat an economy that is struggling, not thriving. When the next recession does come around, the Fed will presumably need some “dry powder” in the form of interest rate cuts to deploy as a countermeasure. Maintaining that powder supply through intelligent and frugal management of the interest rate is likely the Fed’s goal. They don’t want to derail the expansion any more than the President does, but managing our interest rates for the long term is a critical and worthwhile goal of the Federal Reserve.
Thursday followed up the Fed’s fireworks with another series of tweets from President Trump regarding the trade negotiations with China and the announcement of the administration’s plans to impose “a small additional Tariff of 10%” on the remaining $300 billion of imports from the country. The new tariff does not include the 25% tariff that is already in effect. In the short aftermath following Powell’s post rate cut press conference, the announcement of additional tariffs on Chinese imports only exacerbated further selling in the market. This morning saw the announcement that China would be devaluing its currency; a move that has sent markets sinking lower and a move that perfectly encapsulates the “currency manipulation” the US President has frequently drawn attention to. A weakened Chinese yuan causes Chinese goods to be cheaper relative to the dollar. Many see that as a short-term effective countermeasure against the US administration’s tariff policies. A potential escalation from the United States could see the official labeling of China as a currency manipulator, a move the administration threatened but did not pursue three months ago. No country has been named a manipulator since the Clinton administration did so for China in 1994.
In January, public perception seemed to be that a trade agreement between the two nations was in their mutual best interest and would be a likely conclusion by the end of the summer. Those odds certainly haven’t gotten any better. In fact, there have been some arguments that the President plans to run with the China trade war as a campaign issue, pressing the eventual Democratic candidate on their ability to “stand up” to China and continue the pursuit of tough negotiations. The likely frontrunner for the party, former Vice President Joe Biden, was a part of the Obama administration that negotiated the Trans-Pacific Partnership (TPP), the very free trade agreement that President Trump campaigned against Hillary Clinton with in 2016. Former VP Joe Biden has already stated in the Primary debates that his method in resolving the current trade war with China would involve renegotiating TPP in a multilateral agreement. While conventional wisdom would tell us that achieving a trade agreement and cease fire that lifted the tariffs would be a valuable political win for the current President, there exists the possibility that the administration may not see a deal as a necessity going into the 2020 election. Furthermore, while the Chinese economy has experienced some very damaging effects from the ongoing trade war, they may agree with President Trump that his potential 2020 rival may provide them more flexible terms in reaching an agreement.
While the speculation regarding the Federal Reserve’s interest rate policy and the ongoing US-China trade war have been owning the market headlines, last week also saw the continued reveal of Q2 earnings and a number of interesting economic data releases. Almost 78% of the S&P 500 have reported earnings for the previous quarter so far. 59% of those companies have beaten their sales estimates while 76.5% of them have beaten earnings estimates; on the sector level, Financials, Healthcare, and Real Estate have been strong standouts. The dissonance seen between earnings and sales can be explained by the current stock-buy backs propping up earnings. Q2 is currently tracking for 2% year over year growth but margins are expected to experience continued contraction into Q3 where we may actually see a year over year earnings decline. Fortunately, Q4 is expected to produce a rebound that should bring 2019 earnings to growth in the range of 4-5%. The arguments that we are in an “earnings recession” are premature at best. On the economic data front, what we’ve seen recently has been for the most part quite good. Today’s jobs report showed that payrolls increased by 164,000 during July bringing the total labor force to a record-high 163.4 million. Unemployment stayed the same at a low 3.7%. Inflation (using the Fed’s preferred measure the PCE deflator) remains remarkably low at 1.5%; the Fed’s target rate is 2% which was likely one of their reasons in pursuing the recent rate cut. The most prominent negative piece of economic data recently was Q2 GDP growth being reported at 2.1%, along with Q1 being revised downward to 3.1%. These numbers paint a slightly disappointing picture that shows GDP growth peaked in 2018 as opposed to Q1 2019. However, the data still points to annual economic growth this year and next year barring some sort of shocking development.
The start of August has continued pushing a theme we’ve outlined several times in previous newsletters; short-term volatility is driven by headlines while the long-term trend moves with the data. To be clear, both aspects are important in determining the state of our markets and the economy. However, the former is a flashy and quickly changing component, while the latter is what should dictate a longer-term strategic investment allocation. We believe the trade war poses a risk to equity markets until we see some real, tangible progress, and we will continue to monitor the Fed’s interest rate policy going forward. Some of the adjustments we made in June to our client portfolios, which included trimming some of the overall equity exposure, shifting equity positions toward Domestic Large Caps, and reallocating to higher quality fixed income were taken with these risks in mind. For the foreseeable future, the overall economic and market environment continues to be constructive for a diversified investment portfolio.