In this article we highlight:
- Recession fears, which were exacerbated by weaker-than-expected economic data before the market quickly rebounded amid prospects of lower interest rates and continued strength in the labor market
- The market, which we believe likes the concept of “2 and 2,” as in two more rate cuts this year and 2% economic growth in 2020
- Wild cards, including upcoming trade talks this week with China and gathering impeachment momentum against President Trump
- The outlook going into 2020, which we believe remains favorable; however these developing wild cards will need to be watched closely
The month of October started with a bang as investors experienced a roller coaster week to begin the fourth quarter. Weaker-than-expected economic data sent the S&P 500® tumbling close to 5% between its September 30 close and intra-day low on October 3, as fears of a recession in the year ahead once again took center stage. However, rising expectations of more rate cuts by the Federal Reserve and comforting employment numbers provided for a rebound, leaving stocks only slightly down for the week. If nothing else, the week helped to display just how tenuous short-term upward and downward trends could ultimately prove to be in the final months of the year.
Important considerations of this volatile week include:
ISM Manufacturing and Service PMI reports accelerated recession fears. Speculation as to whether a recession is in the cards for the U.S. economy during the year of 2020 geared up a notch on October 1. That day, the Institute of Supply Management (ISM) released its September Purchasing Manager’s Index (PMI) report displaying a contractionary level of 47.8, its lowest report in more than 10 years. This was followed on October 3 by the ISM Non-Manufacturing PMI that, while still expansionary at 52.6, was about three points below expectations. The combination of these two lower-than-anticipated numbers with the existing skittishness in the markets stemming from the lack of a U.S.-China trade resolution was more than enough to send stocks spiraling downward to the tune of more than 4% between the mornings of October 1–3. In regard to these two disappointing reports, we emphasize that they do represent just one month’s data and not yet a real trend, and that potential progress on the U.S.-China trade dispute could easily reverse the psychology behind these surveys.
After about mid-morning on October 3, rising expectations of Federal Reserve rate cuts, potentially in October and December, drove equities into recovery mode. By the week’s end, Fed Funds futures markets were reflecting better than an 80% probability of a .25% reduction at the October 30 Fed meeting and just under a 50% probability of an additional .25% at the December meeting. This not only provided a dose of confidence to the markets, it reminded investors that in the event the Fed does cut rates at both meetings it will have completely negated all four rate hikes of 2018, potentially reducing the Fed Funds rate back to a range of 1.25%–1.50%. In addition, the 10-year to 2-year Treasury bond yield curve steepened to a spread of .12% (1.52% vs. 1.40%), its highest differential since early August, further allaying some concerns.
The September Nonfarm Payroll Report, released on October 4, also seemed to provide comfort to the markets. With 136,000 new jobs added to the economy and upward revisions of 45,000 for July and August, this report soothed some of the immediate concerns from earlier in the week. In addition, the unemployment rate of 3.5% was the lowest in a half century. This continued strength in the labor market combined with rising expectations of more rate cuts was likely the major factor behind the strong rally in stocks (S&P 500 +1.4%) on October 4.
We believe the market could also be setting up for a “2 and 2” scenario of two more rate cuts between now and year end and 2% economic growth in 2020. We believe such a combination is clearly within a strong realm of probability and could represent the “Goldilocks“ scenario that market bulls believe could propel stocks in the year ahead. When combined with benign inflation and positive corporate earnings, we feel stocks for the most part are valued quite favorably for such an environment.
We also believe two major wild cards remain for investors as we enter the final months of 2019:
U.S.-China trade negotiations are once again front and center for the markets as delegation talks take place in Washington on October 10–11. In our opinion, these upcoming discussions between U.S. and China trade delegates are of critical importance and it is becoming vital that progress on a resolution be reached by year end. If not, both U.S. and global growth forecasts for 2020 are likely to be revised downward. In the event a resolution is reached in the next few months and tariffs are eliminated or materially reduced, then we believe there will be meaningful upside to both gross domestic product and corporate earnings expectations in the year ahead. While there is plenty of speculation as to how this drama will play out, we believe in the end it is a binary event that is driven more by personalities and less subject to economic or even political analysis. Stay tuned.
The prospect of Presidential impeachment has gained serious momentum in the past few weeks and could begin to be a gathering cloud over the markets between now and year end. At the current time, it appears as though the market believes President Trump may well be impeached under the definition of a formal indictment by the House of Representatives, followed by an acquittal by the Senate, which would require a two-third majority to constitutionally remove him from office. However, there is much to play out and we believe the markets will certainly react to any emerging developments in conflict or support of this consensus. This soap opera will of course soon dovetail with the official 2020 election season, which promises to be perhaps the most contentious ever.
So in summary, we see more volatility in this final quarter of the year. But we continue to be encouraged by a potential “Goldilocks“ environment in the year ahead of approximately 2% economic growth supported by lower short-term interest rates, benign inflation, rising corporate earnings, and reasonable stock valuations. Investors may want to keep an eye and a half on those developing catalysts with half an eye on the wild cards.
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