Stock markets banking on the Fed to lop rates

Monday, 10th June 2019 09:29 - by Shant

It has been a very good week for Wall Street, with the benchmark S&P 500 reversing all of its losses from April and some.  Amid the storm of trade tariffs from the US and threats of retaliation, we have seen the index hitting a 2730 low, only to recover well over 100pts and cutting the losses from May in half. 

So what's changed? While many analysts point to expectations that the trade disputes with China and Mexico will be resolved at some point, interest rate markets have been busily pre-empting a response from the Fed, who have consistently highlighted their concerns over the escalation of the protectionist policy still being championed by the White House.  This has spurred expectations that the Fed can only respond by cutting the funds rate as the US economy finally starts to feel the effects of this aggressive trade policy.  

Indeed this week, president Trump has trumpeted his view that the US will get a good deal with China, and that Mexico will yield to their demands due to their reliance on the US economy.  We'll see.  As is widely acknowledged, there are no winners in a trade war, and the longer it continues, business confidence and investment suffer - you only need to look at the UK (and Europe for that matter) and the long drawn out Brexit process for more recent validation.  We can tell from the rhetoric, that China at least, is prepared to play the long game. 

Looking at the US Treasury curve, we have seen a sharp inversion which has pulled the benchmark 10yr Note into levels close to 2.00% - hitting sub 2.10% this week.  The belly of the curve (3-5yr) has reached close to 1.75%, which suggests 75bps of rate cuts potentially by the end of this year.  Some may view this as an excessive response given the real economy is performing relatively well in the current climate, but as we have seen in some of the recent data, the pace of activity has slowed in the US, and this should be yet another warning signal for future earnings, and therefore valuations.  Late Friday, the US jobs report also rang alarm bells with a significantly lower rise in the workforce, alongside a slightly softer pace of annual wage growth. 

Alas, the high dependency on cheap money continues to determine the appetite for equities across the board - rather than taking a more differentiated view.  While this may sound negative when taken out of context, one cannot ignore the fact that it does somewhat distort prices across the spectrum of sectors and ultimately hides true value in relative terms.  While there has been a clear rush for fixed income as indicated in long end yields across developed bond markets, overseas investors - notably from Japan (where QE is still very much in full swing) - continue to clamour for yield, through a variety of derivative structures, predominantly ETFs.  At some point - and this may be some way down the road - markets will have to detach themselves with the view that lower interest rates lead to higher lending, thereby spurring growth.  Again, we have clear examples where this is not the case, with Europe having failed to normalise rates from ultra-low levels, yet continuing to suffer from the fall in global aggregate demand.  While lending has been steady, this is clearly not feeding through into increased output.  

In the US, however, lower interest rates - and the Fed has some ammunition now, unlike its counterparts in Europe and Japan - can provide a boost to the economy.  The question now has to be, whether the latest recovery in equity markets is relying on it.  There are a growing number of market participants now calling for a move this summer, with Barclays and Citibank among the names calling for a 50bp cut in July/September.  This naturally puts the pressure on the Fed to cut, and in doing so, could risk damaging their credibility as a result.  This, however, is not the issue.  The series of rate hikes in the normalisation process was effected in order to build up a buffer when the economy suffered a downturn.  Despite the latest payrolls number, unemployment is still at multi-year lows, and the PMI data still points to expansion in both manufacturing and non-manufacturing sectors.  One gets the sense that come the next FOMC meeting, expectations for yet another dovish tilt may be high. As such, stocks could be setting themselves up for some disappointment.  Either way, it will pay to take a pragmatic approach going forward - something Fed chairman Powell seems to have adopted up to this point.  Whether he continues on this path could have clear implications for equities in the months ahead - including the prospect of fresh record highs!  If so, the Fed will be accused of using up bullets a little too early - and perhaps rightly so.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.