Weekly Update: Is bad news good news?

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  • Rate cut hopes spurred market rally.

  • Tariffs threatened against Mexico to curb migrants.  Fortunately or unfortunately, they worked.

  • Did businesses hit the “pause button” in May?

  • Markets now expect three Fed rate cuts this year.

  • Week Ahead: With a bullet dodged on Mexico tariffs, attention likely to center on economic reports.

Rate cut hopes spurred market rally.

As we have stated previously, Via Nova believes a shift to an easier monetary policy from the Federal Reserve is warranted.  Stock markets rallied in the latest week on expectations that the Federal Reserve will change from the steady, “patient” approach to future interest rate hikes and instead cut short term interest rates as early as this summer.  However, those expectations were fueled primarily by weaker than expected employment and manufacturing reports.  Since stock markets tend to respond favorably to lower interest rates, bad news for the economy was good news for investors, for now. 

Up until recently, the U.S. economy hummed along at a healthy pace punctuated by robust job gains and better than expected first quarter GDP growth, all despite slowing economic momentum overseas.  While it is not prudent to put too much weight on a single month’s reports, the cumulative evidence now suggests that domestic economic growth has slowed, which could weigh on future sales and profits.  We believe the odds of a recession remain low and that most of the downside risks are related to policy mistakes on interest rates, trade and domestic politics, as we highlighted at the beginning of the year on our Via Nova Worry Checklist for 2019.  However, slower economic growth could restrain the current equity bull market.

The S&P 500 enjoyed its strongest performance of the year rising 4½% following four weekly declines lifting the index performance in the second quarter back into positive territory.  Materials and technology stocks led the broad advance, suggesting a pro-cyclical reaction to the interest rate news.  Small cap stocks rose less than the large cap S&P 500, but both outperformed international and emerging market stocks.

Bonds benefited from the speculation of a shift toward ease by the Federal Reserve, and the yield on the 10-year Treasury bond fell to 2.08% and pushed the 30-year fixed home mortgage rate slightly below 4%.  In aggregate, the Merrill Lynch Broad Bond Market Index rose another 0.4%.  Other markets were generally positive amid the turmoil.  Real Estate Investment Trusts (REITS), Treasury Inflation-Protected Securities (TIPS) and gold all rose, while the value of the dollar declined on the interest rate news.  Lower interest rates tend to make a currency less attractive, while higher rates tend to boost currency values.

Tariffs threatened against Mexico to curb migrants.  Fortunately or unfortunately, they worked.

Historically, tariffs have been used to achieve economic goals such as correcting unfair trade practices or to support fledgling domestic industries.  However, the Trump administration threatened Mexico with escalating tariffs on nearly $350 billion of goods starting Monday unless Mexico agreed to do more to curb the flow of migrants through their country to the U.S.

The move sent fresh fears through the markets, since Mexico is a very large trading partner and the impact cuts across many industries.  Fortunately, an agreement was reached late Friday whereby Mexico agreed to increase enforcement to curb what Mexico calls “irregular migration,” including the deployment of up to 6,000 National Guard troops throughout the country with a special focus on the southern border with Guatemala.  The tariffs have been suspended indefinitely, and markets should respond favorably to the news.

However, the troubling aspect of the action for investors is trade and tariffs have become tools to conduct foreign policy, where “fairness” becomes much more subjective and industries can be caught inadvertently in the political crossfire.  The avoidance of tariffs on Mexico is great news for many companies, who can continue with “business as usual.”  Unfortunately, the unexpected shock from the threat to use tariffs for political and policy goals will likely remain a source of uncertainty for companies conducting international business.

Did businesses hit the “pause button” in May?

Via Nova believes the risk of a U.S. recession remains low, but the continued turmoil and confusion surrounding trade and tariffs appears to have prompted many businesses to put spending and hiring plans on hold for the time being.  In May, the ISM Manufacturing Survey was weaker than expected and is currently hovering just above neutral; still in positive expansion territory, but well off recent highs.  In addition, the all-important jobs report showed only a small increase in net new hires last month, and that small increase was cancelled by a downward revision to previous months’ gains.  Revisions to previous months’ estimates are common and often reinforce existing trends.  Earlier this year, revisions were generally higher along with strong job growth.  Unfortunately, in the latest report, the smaller than expected gain was accompanied by downward revisions potentially suggesting a shift to slower economic growth.

On the positive side, the unemployment rate remained at a 50-year low of 3.6%, and weekly data on unemployment insurance showed no evidence of an uptick in layoffs.  Average hours worked remained steady and hourly earnings increased 3.1% from a year ago.  Our preliminary conclusion is that, in the absence of clarity on a number of issues, primarily trade, companies put many new spending and hiring plans on hold, which will further curb economic growth in the near term.

Markets now expect three Fed rate cuts this year.

The recent soft economic data suggests growth slowed to around 1½% in the second quarter from just over 3% in the first, and most analysts believe the slowing will be enough to prompt the Federal Reserve to cut short term interest rates as many as three times in the second half of the year.  The surprise weakness in the May employment report lifted the odds of a rate cut by the July Federal Open Market Committee (FOMC) to 85%, which is very high confidence.  Some investors believe the FOMC may act to cut rates at the next meeting June 18-19, but we see that as unlikely.

We believe multiple rate cuts by the Fed from the current 2.50% level are appropriate given the recent softness in key economic reports and the drop in the 10-year Treasury yield to just over 2% creating an inverted yield curve, a potential precursor to a future recession.  However, a rate cut in June is unlikely, in our view, because the Fed has a history of measured, methodical and transparent decision-making and communications.  While hints of the need for a reduction in short term rates have come from several Fed officials, we have not seen a widespread call for lower rates from most voting members yet.  Instead, we expect the FOMC will prefer to communicate a potential policy shift at the June meeting to be followed by a cut in July.  This approach and outcome is consistent with the Fed’s current operating procedure.  If the Fed decides to begin lowering rates, we believe stock prices will benefit.

Week Ahead: With a bullet dodged on Mexico tariffs, attention likely to center on economic reports.

Markets could be bolstered early in the coming week by the immigration agreement with Mexico Friday and the avoidance of fresh tariffs.After that, the attention will likely turn quickly to the next round of economic reports.First will be whether the NFIB small business survey reveals any cracks in confidence or hiring plans.The Consumer Price Index for May follows on Wednesday and will give a sense of the trend in inflation pressures.Finally, the Retail Sales report for May is due Friday, and forecasts call for a healthy 0.6% increase following an April decline.