GUEST BLOG / By Craig Fehr, Principal, Investment Strategist with Edward Jones. Data is current as of August 23, 2019.
Stocks were on track to finish higher for the week until China unveiled a new round of retaliatory tariffs and President Trump vowed to respond, unnerving markets. In this new episode of escalation in trade tensions, China announced that it will impose tariffs ranging from 5% to 10% on $75 billion U.S. goods in two batches, effective on Sept. 1 and Dec. 15, including a 25% tariff on U.S. cars. At the annual central bank summit in Jackson Hole, Fed Chair Powell left the door open for another rate cut when the committee meets next month, acknowledging the risks to global and U.S. growth from trade uncertainty. While the Fed and trade dominate the headlines, it should not be lost that economic and corporate data remain fairly positive. Earnings from several high-profile retailers last week were solid, indicating that the consumer - the main driver of the U.S. economic engine - remains in good shape.
Markets regained a bit of composure for most of last week. That limb wasn't too tough to reach given the comparison is a frantic August in which the Dow rose or fell by more than 300 points in seven of the preceding 10 days. After rising for most of the week, a tariff-induced pullback late on Friday led U.S. stocks lower by 1.4%, extending August's streak of weekly declines1.
So where do we go from here? In our view, the data and recent market moves are consistent with an aging bull market that still has plenty of green leaves. That said, we believe the interest rate and trade gusts that have recently shaken some leaves off the trees will continue to blow. So, when it comes to market volatility, we're not out of the woods yet.
· Limber, not "TIMBER!" – The range of market moves has been stretched out lately, and we think the stock market will remain more limber as investors react to incoming data and headlines. After logging just three total days with a 1%-plus daily move over June and July, the stock market has moved by more than 1% in half of the days in August1. The recent brushfire has been caused by sparks from the trade spat with China and an inverted yield curve. We don't think either will burn the bull market down. However, while not to the tune of regular 800-point daily swings in the Dow, we do think they will continue to be sources of anxiety that keep markets swaying.
o Another branch on the trade saga – China announced last week it would implement a new set of retaliatory tariffs on U.S. goods, which was then met with a tweeted response from President Trump suggesting U.S. companies seek "alternatives to China" -- marking the latest installment in the trade spat that we think will lurch on well into 2020. Exports represent less than 13% of U.S. GDP, and net exports (exports minus imports) are not an overly large contributor to our economy's growth rate. Thus, trade disruptions are a relatively small direct threat for a recession. Our larger concern is the indirect threat that trade poses, to the extent that the uncertainty seeps into overall business investment. Capital spending by U.S. firms and the small business optimism survey have weakened a bit lately (but not collapsed), highlighting this potential spillover effect. Last week's retaliatory rhetoric suggests the gap could get wider before it narrows, as we think U.S. and Chinese policymakers will continue to posture tough respective stances as negotiations continue. Ultimately, however, we think both sides will approach some form of a deal to stave off irreparable economic harm, though the risks of collateral damage are rising. An eventual deal would be good news for the economy more broadly, but the path there is likely to present further knee-jerk market reactions along the way.
o Inverted yield curve continues to throw shade – The inverted yield curve (when long-term rates are below short-term) continues to cast a shadow on stocks amid fears that it's signaling an imminent recession. We're careful not to dismiss this warning because the yield curve has a solid track record. We're also careful not to follow the crowd, as a more detailed assessment of the yield curve shows important differences from the past. Long-term rates have dropped below short-term rates in small part because the outlook for growth has waned (a negative sign), but also in large part because negative rates abroad have attracted buyers of U.S. Treasuries (where yields are low but still well in positive territory), pushing yields lower than they otherwise would be based simply on the domestic growth and inflation outlook. Additionally, the curve has not inverted from steady rate hikes from the Fed (as has been a catalyst for prior inversions). Of the multiple inversions over the past half century, false positives have occurred a quarter of the time, with prior "head fakes" seeing the stock market rise by an average of 14% over the following year2.
We think the current risks are credible, and short-term market pullbacks should be expected. That said, we've seen repeated threats to this bull market over the past several years, including worries over rates and tariffs. 10-year rates fell sharply near current levels in 2012, 2013 and 2016, and the yield curve has inverted twice before in the past 12 months. Stocks fell by an average of more than 5% in response to these factors, followed by double-digit gains over the following year. Similarly, tariff escalations have spurred several pullbacks over the past two years, all of which proved to be temporary.
· Strong roots – The attention has been squarely on the risks of late, but last week the market was stabilized by data showing this expansion still has healthy roots. Consumer spending is more than two-thirds of U.S. GDP, and corporate earnings are the food source for long-term market performance. News last week on the latter gave renewed confidence that the former is still in a position to support the expansion. Very strong earnings results from companies such as Target, Home Depot and Lowe's not only bolstered the corporate profit picture, but provided a read-through showing that the U.S. consumer remains in good shape.
Weekly jobless claims last week fell to their second-lowest level in the past four months, wages have now grown above 3% for 12 consecutive months (the longest such streak since 2007), and the unemployment rate (3.7%) is down from 4% at the beginning of the year and just one-tenth above the 50-year low. The recession signal from the inverted yield curve is getting much of the attention, but household spending will be a key determinant to the economy's future. Looking at the past four U.S. recessions, the unemployment rate had risen by a minimum of 0.5% before each recession began, signaling that the deterioration of consumer conditions is a key ingredient in the recession recipe, and not one that's on the list currently.
· Is the Fed holding an axe or a watering can? - In addition to tariff squabbles and corporate earnings, the Fed was another headliner last week as officials gathered at the annual central bank summit in Jackson Hole, Wyo. With a strong U.S. consumer plus healthy employment conditions on one hand, and a manufacturing downturn, low inflation and trade risks on the other, the markets are looking to the Fed for a policy response to help sustain the expansion. Comments from Fed officials seemed to confirm that the U.S. central bank is likely to cut rates further this year in acknowledgment of the swirling risks.
Our view continues to be that the Fed will lower rates, though we're not yet convinced they will be as aggressive in cutting as the market seems to be anticipating. The economic data suggests moderate cuts may be appropriate to support a soft patch in growth. But to the extent the Fed incorporates trade risks (which were dialed up by the White House last week) into its response, we could see a more aggressive approach to rate cuts. In the end, policy easing from the Fed is a broadly supportive factor for the stock market, though we think any disconnects between market expectations and actual Fed rhetoric/actions will be an additional catalyst for near-term swings in stock prices and interest rates.
The Fed is embarking on a mid-expansion easing cycle. We saw a similar response in the mid- and late-90s expansion, when the Fed cut rates multiple times before resuming rate hikes as the economy exhibited resiliency. It's reasonable we could see a similar outcome this time, as the expansion regains some footing on the back of low rates, household spending and diminished trade fears/rebounding business investment.
· The forest for the trees – It can be easy for investors to miss the forest for the trees, as the wide trunks of trade tensions, yield curves and sharp market moves can obscure the broader landscape. Perspective is a very valuable tool, so consider the following:
o Volatility is the norm, not the exception. Since 2010, the stock market has experienced 28 5% drops and six 10% sell-offs3. Each was hailed as the beginning of the end, and yet this bull market is now more than 10 years old. This one, too, will reach an end at some point, but we don't think this choppy patch is the beginning of the end. For all the hullabaloo surrounding the stock market's August skid, a wider lens reveals a much more encouraging picture. U.S. equities are down a little more than 5% from the all-time high, putting them at the same level as June, when the general sentiment was rather positive and calls for an imminent recession were not deafening. Moreover, the U.S. market has returned 60% over the past five years, more than 21% over the past two years, and has gained better than 15% in 20194.
o Importantly, long-term investing is not simply about stock market returns. A balanced portfolio means you don't have to endure every twist and turn and can travel a smoother path over time. Bonds have gained 2.5% during August5, providing a ballast for portfolios during stock market volatility.
Sources: 1. Bloomberg, daily change in the S&P 500 index. 2. FactSet, yield curve measured by the 10-year U.S. Treasury rate minus the 3-month T-bill rate, total return in the S&P 500 index. 3. FactSet, declines in the S&P 500 index. 4. Bloomberg, total return in the S&P 500 index. 5. Total return of the Barclays U.S. Aggregate bond index.