Weekly Update: Trade tensions continue pressuring stocks.

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  • Good news was hard to find.

  • Economic reports point to slower second quarter growth.

  • FOMC minutes suggest a steady Fed policy, but some members turning more cautious.

  • Week Ahead: Focus on trade again.

While we enjoy the pleasures that come with a three-day weekend, I hope that we all remember the powerful significance of this day and the important sacrifices that have been made in defense of our freedoms by the brave men and women of our armed forces, both past and present.

Good news was hard to find.

Good news was hard to find in the latest week putting more downward pressure on stock prices.  Four items weighed on the markets.  First, trade tensions with China escalated to a new high as the trade war evolved into company-specific actions aimed at breaking the negotiating impasse.  The Trump administration blocked U.S. companies from selling semiconductors and other equipment to Chinese tech giant Huawei, only granting a temporary reprieve for existing orders.  As many as four other Chinese tech companies were also mentioned as potential targets.  Hardball is perhaps a good way to describe the current environment.

Second, fears of slower global growth related to trade, curbed oil demand forecasts pushing down energy stock prices.  Third, several major retailers reported disappointing first quarter results and issued more cautious earnings guidance for the remainder of 2019, hurting consumer discretionary stocks.  Finally, UK prime minister Theresa May announced she will resign on June 7 after being unable to deliver on her Brexit promise.  The process for electing a new leader will begin next week, and a “hard” and potentially disruptive Brexit cannot be ruled out.

The bad news trimmed the S&P 500 a bit over one percent for the week, paced by weakness in the energy, technology and consumer discretionary sectors.  Small caps slightly underperformed the S&P 500, while international and emerging market equities outperformed, though all the major indexes declined.  Stocks are trading lower so far in May with the S&P 500 off just under 4% and emerging markets down over 8%.  This pattern is consistent with continuing trade tensions.

Bonds benefited from the uncertainty once again, and speculation of a shift toward ease by the Federal Reserve increased.  The yield on the 10-year Treasury bond fell to 2.33%, the lowest level in two years, and allowed further declines in home mortgage rates.  In aggregate, the Merrill Lynch Broad Bond Market Index rose another 0.3%.  Other markets were generally positive amid the turmoil.  Real Estate Investment Trusts (REITS), Treasury Inflation-Protected Securities (TIPS) and gold rose slightly, while the value of the dollar edged lower.

Economic reports point to slower second quarter growth.

Via Nova believes the risk of a U.S. recession remains low, but the latest batch of economic reports point to slower second quarter growth despite consumer and labor market strength.  Part of the slowdown is related to temporary factors, such as a draw-down in excess inventories, but part may reflect growing uncertainty about how to conduct business in an environment of escalating trade tensions.  Initial jobless claims, a key leading economic indicator of consumer and labor market strength, remained near five-decade lows, but new orders for long-lasting capital goods softened over the past several months.  Surveys of business activity are generally positive, but also have declined from recent highs.  Current estimates of second quarter GDP from the Federal Reserve Bank of Atlanta are about 1½%, down from over 3% in the first quarter.

FOMC minutes suggest a steady Fed policy, but some members turning more cautious.

It appears that the calm and optimistic outlook at the Federal Reserve may be slowly turning more cautious at last.  Via Nova is pleased to see evidence of a change in the Fed’s perspective and believe a shift toward ease is warranted.  A decline in short-term rates could support economic growth, as well as both the stock and bond markets. 

When the FOMC met at the beginning of the month, downside risks to the economy seemed to diminish helped by lower mortgage rates and expectations of a trade deal with China, according to the meeting minutes released this week.  “Participants continued to view sustained expansion of economic activity, with strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective as the most likely outcomes.”  “A number of participants observed that some of the risks and uncertainties that had surrounded their outlooks earlier in the year had moderated, including those related to the global economic outlook, Brexit, and trade negotiations.  That said, these and other sources of uncertainty remained.”

We agree the risks reflected in the Via Nova Worry Checklist for 2019 have eased in recent months and helped the S&P 500 rise to a fresh record high.  However, that progress stalled in May on several fronts in a kind of “two steps forward and one step back” raising the downside risks to our economic outlook.  Most importantly, China trade negotiations ground to a halt short of an agreement.  Comments from Chinese officials have taken on a more strident, nationalistic tone suggesting the negotiations could be protracted.  The resignation of the UK prime minister suggests continued turmoil and uncertainty in Brexit negotiations.  These global developments have helped put downward pressure on stock prices and bond yields so far in May.

The Federal Reserve wants to continue “normalizing” monetary policy, raising short-term rates comfortably above zero and shrinking its balance sheet, in preparation for the next inevitable economic slowdown.  That approach is a laudable goal, but the steady progression of interest rate hikes in 2018 may have gone too far and risks short-circuiting the current expansion.  The result would be what we call a self-inflicted wound.  Indeed, as we have mentioned previously, the current level of the Federal Funds rate could be too high relative to longer term yields causing a flat yield curve that distorts the credit markets.  The debate within the Fed is likely to continue at least for several more months, depending on economic and trade developments.  For now, the FOMC intends to keep interest rates steady indefinitely, and Chair Jerome Powell asserted there was no strong will to move rates in either direction.  Fortunately, some dissension among FOMC voters has become more evident.  Kansas City Fed President James Bullard conceded that the rate hike back in December may have "slightly overdone it."  We agree.

Week Ahead: Focus on trade again.

Trade news will again be the primary focus in the holiday-shortened week.Markets will likely bounce from one tweet and rumor to the next.The economic calendar will be light, with updates in personal income and spending on Friday attracting the most attention.