HIGHLIGHTS:
Better news on the Fed, China trade and oil prices helped lift stocks.
Inflation was muted in 2018.
The Fed can afford to be “patient” raising rates.
China trade talks are making progress.
Government shutdown hits a record length.
The Week Ahead: Earnings season kicks into gear.
Better news on the Fed, China trade and oil prices helped lift stocks.
The stock markets continued to climb the “wall of worry” for a third consecutive week, boosted by better news on future Fed interest rate policy, China trade negotiations and oil prices. Via Nova is very encouraged by the character of the rebound since Christmas Eve. The more cyclical sectors of the market have regained some traction, possibly reflecting greater economic confidence, and the recovery in small cap equities suggests greater participation from the broader market. The jury is still out on the durability of the latest stock market move, but our most likely scenario suggests that the market will trend higher over the course of 2019.
The encouraging news on future Federal Reserve Interest Rate Policy, China Trade Resolution and Energy Prices/Potential Cutbacks help address three of the items on the Via Nova “Worry Checklist for 2019”, with Trade and Interest Rates near the top. The S&P 500 gained 2½% for the week and has regained almost half of the correction between September 20 and December 24. The pro-cyclical industrial, energy, consumer discretionary and technology stocks led the advance for the week and since Christmas Eve. Financials remain a stubborn laggard, though prices did rise. Another encouraging sign is that small cap stocks outperformed the S&P 500 as did international and emerging market stocks suggesting broader market participation.
In other markets, bond yields inched higher on the week, but the 10-year Treasury yield at 2.7% is well below the 3.25% peak as recently as November. Mortgage rates have fallen as a result, which will likely provide a boost to home sales. The Bloomberg/Barclays Aggregate Bond Index finished virtually flat, but high yield bonds gained 2%, as credit spreads narrowed – again, a sign of improved investor optimism. Oil prices rose above $50/barrel, which should support improved energy earnings and reduce the risks of production cuts and layoffs. Real Estate Investment Trusts (REITS) and Treasury Inflation-Protected Securities (TIPS) also gained, but gold prices cooled. The dollar was slightly lower. A weaker dollar raises import prices but makes U.S. goods more competitive in the world markets and is positive for corporate earnings.
Inflation was muted in 2018.
The Consumer Price Index report (CPI) showed continued low, but mixed, inflation in 2018. Prices fell -0.1% last month due mostly to falling energy costs, and the CPI rose just 1.9% for all of 2018, slightly below the 2% Federal Reserve target. Low inflation limits the need for interest rate hikes. However, the overall muted inflation report was a mix of weaker and stronger prices. In general, prices of more discretionary items, like cars and clothes fell last year, as did energy prices, while prices of necessities, such as rent and medical services, rose faster. Low and stable inflation is a market positive, keeping interest rates lower and lifting the value of future corporate earnings, and with it, stock prices.
The Fed can afford to be “patient” raising rates.
The message from the Federal Reserve continues to suggest a more cautious approach to tightening this year, which helps keep interest rates lower. Fed Chairman Jay Powell referred to the various risks facing the economy and stated, “We are in a place where we can be patient and flexible and wait and see what does evolve.” Currently, the markets are pricing in little chance of any rate increases this year in contrast to four in 2018.
The minutes of the December Federal Open Market Committee (FOMC) meeting provided some useful color on the Fed’s thinking on the various risks facing the economy. “In assessing the economic outlook, participants noted the contrast between the strength of incoming data on economic activity and the concerns about downside risks evident in financial markets and in reports from business contacts.” Potential downside risks mentioned in the minutes mirror many of those on Via Nova’s Worry Checklist for 2019: “a sharper-than-expected slowdown in global economic growth, a more rapid waning of fiscal stimulus, an escalation in trade tensions, a further tightening of financial conditions, or greater-than-anticipated negative effects from the monetary policy tightening to date.”
We believe the Federal Reserve will indeed move more cautiously in raising interest rates over the near term. If there is improvement in these risks, many of which are policy-related (self-inflicted), growth in the economy and earnings could improve, and the Federal Reserve could resume normalizing interest rates later in the year. Under this scenario, a resumption of Fed tightening would not be a significant headwind for stocks, but it would be for bonds.
China trade talks are making progress.
The incremental information related to the China trade talks continued to improve, which is positive for equities. The lower level discussions in the latest week were extended an extra day, raising optimism that progress is being made, though details have been scarce. Higher level talks are scheduled here in the U.S. in the next few weeks. Talk is good as it improves the chances of an agreement. The latest Chinese manufacturing and spending data showed slowing and contraction, which may suggest a greater willingness to negotiate a trade agreement with the U.S. However, many analysts believe the trade tensions with China could also exert a dampening effect on fourth quarter earnings. While we believe most of the “pain” from the trade tariffs has fallen on China, the U.S. has not been immune. An agreement would be good for both sides and for the global economy.
Government shutdown hits a record length.
The partial government shutdown has now exceeded three weeks and reached a new longevity record. Affected government workers missed their first pay check on Friday, and many are having to scramble to make ends meet. While the Congress has yet to agree on a final spending package, both houses came together to pass legislation guaranteeing that workers will receive back pay once the government reopens. Estimates of the economic impact of the shutdown vary, but the drag on growth might be only a few tenths of a present at most. Via Nova believes the government shutdown is more about politics and posturing than broad philosophical differences. We believe the shutdown is likely to be one of many episodes aimed at stirring voter unrest ahead of the 2020 Presidential election. We expect more in the future.
The Week Ahead: Earnings season kicks into gear.
Fourth quarter earnings season kicks into gear this week and will be the primary focus for most investors.S&P 500 earnings are forecast to grow a bit over 10% from a year ago, which is lower than the 20% plus gains posted earlier in the year, but still above the historical average.The anniversary of the corporate tax cuts is a primary reason for the slower expected growth, but some companies have announced that trade tensions with China have also had a negative impact on earnings.However, it is worth noting that the number of negative preannouncements is lower than the average over the past five years.Analysts will comb through the sales and earnings data for the quarter and will be listening to senior management carefully for guidance on 2019 profit gains.