August Investment Comments
A famous investor once said, “Most of the time the Fed is not that important; occasionally it’s the only game in town.” While the Fed is not the only thing that matters in the current environment—trade, for one, is another notable factor driving markets—one could certainly make a reasonable case that it has been the primary influence on market performance since the back half of 2018. Last year, markets sold off following the Fed’s September 2018 meeting when, for the eighth time since 2015, it increased its target overnight lending rate and no longer referred to its own monetary policy as “accommodative.” Subsequent to that meeting, Chairman Jerome Powell also stated his belief that the Fed was still a “long way from neutral” (i.e., rates that are neither stimulative nor contractionary), implying several more rate hikes were on the way and sending markets lower.
In December, the Fed again increased rates while also signaling two rate hikes for 2019. This was more aggressive than the market was anticipating, particularly in light of global economic uncertainty and ongoing trade disputes. In response, markets took another leg down, declining a total of nearly 20% between the end of September and the Christmas Eve low. For the year, the S&P 500 fell 4.4% despite earnings growth of approximately 20%.
After the December meeting, Powell changed his view, indicating that interest rates remained “just below” neutral for the economy, and the Fed’s stance shifted toward “patience” in assessing the incoming data and away from a bias toward continued rate increases. This shift helped improve investor sentiment. The Fed maintained its “patient” posture through its May meeting but following its June meeting dropped the word “patient” in favor of an even more accommodative stance, with the pendulum now swinging toward expected rate cuts. Importantly, Chairman Powell also emphasized a bias toward acting earlier than later, citing the Benjamin Franklin axiom that “an ounce of prevention is worth more than a pound of cure.
In recent testimony to Congress, Powell offered dovish commentary, helping cement expectations for a rate cut by citing inflation that has been running below the Fed’s 2% objective, and crosscurrents, such as trade tensions and concerns about global growth, which have been weighing on economic activity and the outlook. The Fed’s preferred measure of inflation known as “Core PCE,” has slowed down this year and was 1.6% in May.
Looking at the Fed’s stance since the second half of 2018, it has undergone a fairly dramatic shift from emphasizing the normalization of policy via rate increases to a goal of sustaining the expansion via what appear to be likely rate cuts. The Fed Funds futures market is pricing in the certainty of a rate cut at the next Federal Open Market Committee meeting at the end of July, and nearly a 70% chance of an additional rate cut at its September meeting.
There may be some slowing, but the economic picture in the U.S. continues to look reasonably good. GDP grew by 3.1% in the first quarter, and the Atlanta Fed’s GDPNow estimates growth of 1.6% for the second quarter, resulting in growth of 2.4% in the first half of the year, which is respectable. The unemployment rate of 3.7% in June is near a 50-year low. Job gains averaged a solid 172,000 per month from January through June, below the 223,000 per month average in 2018 but comfortably above the 100,000 jobs per month economists believe is needed to accommodate new workers entering the labor force. In another positive sign, consumer spending, which was weak in the first quarter, has rebounded with a solid second quarter, underscoring the resiliency of the U.S. consumer. Even though manufacturing surveys have been weaker of late, impacted by trade-related headwinds, they still indicate growth.
On the trade front, President Trump and Chinese President Xi Jinping agreed to a truce at the G20 meeting at the end of June. The two agreed to resume trade talks, and President Trump agreed to hold off on tariffs on an additional $300 billion of Chinese goods while negotiations continued. The market response was favorable, showing that despite its heavy influence, the Fed isn’t the only game in town. Expect trade negotiations to continue to influence the market. Furthermore, as we get closer to the 2020 election, political factors will also likely exert a greater influence on market performance.
EPS growth for the S&P 500 in Q1 was 0.8%. According to FactSet’s Earnings Insight, the consensus is for a 3.0% decline in EPS in Q2. Accounting for the average earnings “beat” over the past five years, this actually implies EPS growth of approximately 1%. For the year, earnings are expected to grow over 2%, as we lap the tax cuts from a year ago and companies manage the headwinds from tariffs. Given some of the cross currents the Fed is monitoring, a particularly close eye will be given to companies’ forecasts for the remainder of the year.
Market returns generally follow earnings growth over the long run, but this correlation is loose over short periods of time. Keep in mind that the market was down last year despite 20% EPS growth. Furthermore, headline returns for this year have benefitted from a cosmetic lift given the market’s swoon in late December. Year-to-date returns on the S&P are approximately 20%, but on a 52-week basis returns have been closer to 8%.
Expect the Fed, trade, and political factors to continue to impact market performance. Investing in quality, durable, growing businesses is a sensible investment strategy no matter which of these factors is driving short-term performance. Over long periods of time these are the types of companies that are most likely to allow investors to achieve their objectives.
James M. Skubik, CFA