VIA NOVA UPDATE: Avoiding self-inflicted wounds.

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  • Mostly constructive policy developments helped stocks hold recent gains.

  • Economic reports show the U.S. economy healthier than the EU and Japan.

  • A temporary agreement ended the record government shutdown.

  • The Week Ahead: Market fireworks?Earnings, trade talks and an FOMC meeting.

Mostly constructive policy developments helped stocks hold recent gains.

Following four weeks of gains that had lifted the S&P 500 by over 13% since Christmas Eve, stocks finished the week mostly unchanged.  At Via Nova, we believe most of the current risks to the markets are policy-related, or what we might term as “self-inflicted” wounds including raising interest rates too high too fast, escalating a trade war, or suffering a prolonged government shutdown.  These risks among others are on our Via Nova checklist

The markets received favorable developments on at least two of those risks in the latest week.  First, the President and the Congress agreed to reopen the federal government for another three weeks while intense negotiations on border security continue.  The move was more of a band-aid than a solution, and the rancor is likely to continue.  Still, the government is back open, which is good. 

On the interest rate front, the Wall Street Journal reported that the Federal Reserve is looking into whether they should slow the runoff in their balance sheet of Treasury and mortgage securities.  As background, the Federal Reserve employed two extraordinary policies to support the economy in the aftermath of the Financial Crisis.  The first was to lower interest rates to zero and commit to leaving rates low for an extended period.  The second move was for the Federal Reserve to buy trillions of dollars in Treasury and mortgage debt to help keep rates low and improve market functionality or liquidity.  Neither policy was intended to last indefinitely.  The Fed would gradually raise interest rates to a “neutral” level and would let the portfolio of securities gradually mature and runoff.   Thus far, the Fed’s intention has been to use interest rates alone as its primary policy tool and let the portfolio of securities mature on “autopilot.”  When the Federal Reserve holds fewer securities, the private market must hold more, which tends to prop up bond yields and reduce liquidity in the system.  Revisiting the “autopilot” policy of letting securities runoff could add liquidity to the markets and support both the stock and bond markets during this period of economic and policy uncertainty.  This shift would be in addition to delaying additional rate hikes.

For the week, the S&P 500 slipped less than a quarter percent, led by a recovery in technology stocks.  Small cap stocks held steady, and international stocks rose slightly.  Corporate earnings reports were generally favorable, though uncertainty over the outlook remains high.

In other markets, Treasury yields edged lower and credit spreads narrowed, reflecting Federal Reserve caution and general market economic optimism.  The combination helped lift the Bloomberg/Barclays Aggregate Bond Index back into positive territory for the year.   Oil prices stabilized near $53/ barrel but remained volatile, following the decision by the U.S. and other countries to recognize Venezuela’s opposition party leader as the rightful president.  Expect further escalation on this issue, since the military is backing the current president, Nicolas Maduro as are Russia, China and Cuba.  Real Estate Investment Trusts (REITS) and gold gained, but Treasury Inflation-Protected Securities (TIPS) fell.  The dollar weakened on news the Fed might adopt a more conservative approach to reducing its balance sheet.  The dollar is 7% higher over the past year, which tends to lower import prices but makes U.S. goods less competitive in the world markets and is a potential headwind for corporate earnings if the trend persists.

For the week, all the pluses and minuses added up to a volatile but mostly flat market.

Economic reports show the U.S. economy healthier than the EU and Japan.

The government shutdown once again limited the release of some economic reports, but the data from nongovernmental organizations pointed to a healthy U.S. economy, particularly relative to the rest of the world.  The level of weekly initial jobless claims fell to the lowest level in 50 years, signaling a strong labor market and a healthy consumer.  Sales of existing homes were weaker than expected in December, but that data reflects home closings rather than new signings that appear to have increased following the recent decline in mortgage rates.  Recession risks remain low in our view, which limits the downside risks to corporate earnings and the stock market.

The level of economic activity in the U.S. remained steady at a high level in January, according to monthly measures from Markit Economics.  However, the firm noted that growth slowed in both the EU and Japan and is hovering near flat.  Weaker exports have been a key factor holding back growth in many of these export-driven economies, including China.  We believe the current trade tariffs have had a greater negative impact on our trading partners than here at home.  Renegotiated trade deals could offer a significant boost to international markets, which have underperformed the S&P 500 by roughly 10% over the past year.

The weakness in foreign economies has not gone unnoticed by central banks.  The European Central Bank noted the downside risks to the outlook and could delay tightening measures even longer.  Japan is also keeping interest rates low or negative given the weakness, and China is implementing additional stimulus.  Economic weakness is obviously a concern, but central bankers appear to be avoiding a self-inflicted wound of blindly raising interest rates.

A temporary agreement ended the record government shutdown.

President Trump reached a deal with congressional leaders Friday to end the record 36-day shutdown and reopen the government for three weeks despite getting no new funding for a border wall.  Unfortunately, this deal does not eliminate the risk of another shutdown in February.  Rather, it sets the stage for what are likely to be rancorous talks to bridge deep disagreements between Democrats and Republicans on immigration policy.

As stated previously, we believe this perpetual brinksmanship and vindictive acrimony will be a constant worry and threat to the markets through the next election in 2020.  Expect more of this unfortunate behavior rather than less.

The Week Ahead: Market fireworks?  Earnings, trade talks and an FOMC meeting.

Earnings season jumps into high gear this week as 20% of the companies in the S&P 500 report earnings compared to 10% in each of the previous two weeks.  Topline sales growth and bottom line profit gains will be closely analyzed as well as management’s forward guidance given the global economic uncertainty. 

A deluge of earnings reports would normally be more than enough to handle, but the next level of China trade talks resumes, and the outcome could have a significant impact on the markets.  Reducing the trade balance with China will be important, but so will progress in eliminating China’s alleged illegal trading practices.  The most favorable outcome would be a comprehensive plan to address these issues to be subsequently signed by Presidents Trump and Xi later.  A more likely outcome is enough progress to prompt President Trump to hold off imposing additional tariffs a while longer.  A negative outcome would be no progress and a reiteration of the promise to raise additional tariffs.

We will also have a Federal Open Market Committee (FOMC) meeting followed by a press conference.  No interest rate changes are expected, but analysts will look for clues from Chairman Powell on whether and how long the Fed will hold off on further interest rate increases.  Analysts will also listen for clues as to whether they might slow the decline in their holding of Treasury and mortgage securities (mentioned above).  We believe the FOMC could keep interest rates steady through the first half of the year while many of the swirling uncertainties are addressed.  If the Fed also pauses the securities runoff, that would be relatively stimulative and a positive for both the stock and bond markets.

Finally, the January employment report is due Friday, and the market is looking for a healthy gain of over 170,000 jobs and a dip in the unemployment rate.This report would be very healthy, if it happens, but don’t be surprised if the numbers come up short of expectations.Jobs surged in December by over 300,000.Historically, such outsized gains are often followed by smaller increases in the following month.