HIGHLIGHTS:
Dovish comments from the Fed helped lift the S&P 500 to a record high.
FOMC suggests rate cuts are coming.
Manufacturing slowed but housing picked up.
Week Ahead: Housing and income data due, but the focus will be on the Trump-Xi meeting.
Dovish comments from the Fed helped lift the S&P 500 to a record high.
As most of us are painfully aware, the Federal Reserve does not change its policy quickly or easily. We noted that the Fed raised short term interest rates throughout 2018 despite evidence of slowing global economic growth and rising trade tensions. We argued that it was a mistake and one of the major risks facing the economy and the markets in 2019. When short term rates (controlled by the Fed) rise above long-term rates (set by market forces) as they have this year, the credit markets become distorted and economic growth is stunted. Slower growth hurts sales and profits and stock prices.
Fortunately, the accumulating evidence of weakening economic momentum, combined with below target inflation reached a point and finally got the attention of the Federal Open Market Committee (FOMC). While the Fed left short term rates steady at their latest meeting, they acknowledged the growing risks to the economy and the failure of inflation to move up to their long-term 2% target and opened the door to rate cuts as soon as the end of July. The prospect of lower rates boosted investor confidence and helped lift the S&P 500 to a new record high and pushed down the yield on the 10-year Treasury note to 2% and mortgage rates below 4%. Other central banks also adopted a lower interest rate approach recognizing the need to provide support to a slowing global economy. The shift in the Fed’s policy stance away from “patient” toward lower rates had the additional benefit of weakening the value of the dollar from recent high levels, which makes exports more competitive.
The S&P 500 rose over 2% for the week on its way to a record high. Technology, healthcare and industrial stocks outperformed the broader index, though all sectors gained for the week. Energy stocks outperformed due to increased tensions in the Middle East with Iran and an explosion in a Philadelphia gasoline refining plant, both of which threatened to reduce the available energy supply. International and emerging market stocks outperformed, mostly due to the weaker dollar which makes foreign investments more valuable. Small cap stocks lagged the S&P 500 again, perhaps reflecting the slower pace of U.S. economic growth.
The decline in bond yields helped the Merrill Lynch Broad Bond Market Index gain another 0.4%, led by corporate bonds which benefited from narrower credit spreads versus Treasuries. Other markets were generally positive. Real Estate Investment Trusts (REITS), Treasury Inflation-Protected Securities (TIPS) and gold all rose.
FOMC suggests rate cuts are coming.
As we expected, the Federal Open Market Committee (FOMC) held short-term interest rates steady at their June 18-19 meeting, but communicated a probable shift toward lower rates in the coming months. We expect at least two rate cuts in the second half of the year, which could offer support to the economy as well as both the stock and bond markets which rallied following the news on Wednesday.
The Fed opened the door to an easier monetary stance in both the post-meeting statement and in Chairman Powell’s post-meeting press conference remarks. The post-meeting statement indicated a softening in employment and economic growth in recent months and a further drop in inflation below the Fed’s 2% target – the two mandates for Fed policy. Confirmation of slower growth and falling inflation suggests a recognition that a more accommodative shift may be in order, and this was reflected in the individual economic and interest rate projections, or “dot plot,” where half of the members now expect at least one rate cut in the second half. Indeed, Kansas City Fed President James Bullard dissented from the other voters at the meeting in favor of an immediate quarter-point rate reduction, and the Minneapolis Fed president argued for a half-point cut.
In the press conference, Powell highlighted the shift in momentum, “In the weeks since our last meeting, the crosscurrents have reemerged. Growth indicators from around the world have disappointed on net, raising concerns about the strength of the global economy. Apparent progress on trade turned to greater uncertainty, and our contacts in business and agriculture report heightened concerns over trade developments.” “Against this backdrop, inflation remains muted.” “Many FOMC participants now see that the case for somewhat more accommodative policy (translation: lower interest rates) has strengthened.”
Manufacturing slowed but housing picked up.
The latest batch of economic reports were mixed showing a continued loss in manufacturing momentum but also a pick up in housing activity due to lower rates. Key measures of manufacturing activity hovered close to neutral, placing a drag on second quarter economic and earnings growth. The slowing was not completely unexpected given the sharp rise in inventories in the first quarter, and we continue to believe the risk of recession remains low. However, uncertainties surrounding trade with China continued to weigh on production and investing, with Apple reaching out to its suppliers to explore moving their manufacturing away from China into countries such as Viet Nam and India to avoid tariffs.
The good news of the week came from housing, where lower mortgage rates boosted home sales. Mortgage rates have fallen from a high of 5% to below 4%. That drop reduces the monthly payment on a $200,000 30-year mortgage by $125 month or $1,500 a year. If the Federal Reserve cuts rates as expected in the months ahead, we could see further gains in the housing sector.
Week Ahead: Housing and income data due, but the focus will be on the Trump-Xi meeting.
Markets may hover for most of the second quarter’s final week, as investors wait for any signs of progress between the U.S. and China toward a trade agreement. Presidents Trump and Xi are due to talk at the G-20 economic meeting in Japan and many are optimistic that the two sides will show progress. Lack of progress or a continuation of nationalist rhetoric would be negative for the stock market.
The economic calendar will offer updates on durable goods orders, personal income and spending as well as updates on the Fed’s preferred inflation measure, the Personal Consumption Expenditures Deflator or PCE, which is running below the FOMC’s 2% target.Scheduled comments from several FOMC members could provide additional insights and when and how much the Fed might cut rates in the coming months.