So much for the lazy days of summer. This year’s solstice season has started with a bang.
May kicked off with the unexpected breakdown of negotiations between the U.S. and China, culminating in the failure to reach a trade agreement. As a result, the U.S. imposed tariffs on an additional $200 billion in Chinese imports, followed by retaliatory tariffs by China of $60 billion more. Then on May 31, President Trump announced intentions to impose 5% tariffs on Mexico, not for economic reasons but as leverage on immigration policy.
This rekindled recession concerns in the U.S. and sent off warning bells throughout the global markets. Stock prices and bond yields fell as the 10-year Treasury rate declined to 2.06%, its lowest level in almost two years. The 3-month to 10-year Treasury yield curve inverted for the second time this year, and by the close of trading on June 3, the S&P 500® was approaching correction territory as it had fallen 7% from its late-April record high.
Enter the Federal Reserve and the words of Chairman Jay Powell. He said they would "act as appropriate to sustain the expansion," in a direct reference to the impact tariffs on China and Mexico might have on the U.S. economy. The markets quickly penciled in higher probabilities of rate reductions between now and year-end. By Friday June 7, the S&P 500 had recovered most of its losses from late April.
Two important developments also occurred on June 7. The first was the May Employment Report, which missed expectations by a wide margin, displaying job gains for the month of only 75,000 compared to most forecasts of about 180,000. Downward revisions for March and April totaled another 70,000 jobs. This was viewed by the market as further increasing the probability of faster and more accommodative action by the Fed, and despite the negative economic news, stocks continued moving higher. Later that day, the White House announced an agreement had been reached with Mexico and the 5% tariffs would not be imposed.
All of this left investors gasping for breath before most had even fired up their backyard grills. So here's a summary of what we believe to be most important this time:
The markets are now discounting between two and three rate cuts between now and year end, or what might also be considered to be a mini-easing cycle. This is quite extraordinary given that just six months ago, most were debating between two and four rate hikes for the year. Fed Funds futures are now forecasting about a 25% probability of a rate cut in June (that's right, JUNE), better than a 70% probability in July, and close to 100% by September and December.
The market has made the determination in recent days that it prefers the upside of lower interest rates to a greater extent than it fears the downside risk of economic uncertainty. It is important in our opinion for investors to recognize this, as it creates the risk of disappointment if the Fed does not deliver but also a better upside scenario should a trade agreement be reached and economic sentiment improves. At the current time, we would lean toward the latter upside potential.
While the trade dispute with China continues to represent the biggest wild card to investors, there is still a path to a silver lining, or what we would refer to as a Goldilocks scenario for 2020. It goes something like this: The Fed cuts rates a couple or three times to assure a recession will be averted and the yield curve steepens in response. The U.S. and China then manage to come to terms in the second half of the year on a trade agreement and tariffs are curtailed or removed. After a likely 2Q19 gross domestic product print of 1.0%-1.5% growth, economic activity picks up in 2H19, paving the way for better than 2% economic growth for the year and double-digit corporate earnings growth is on the table for 2020. This scenario, in our opinion, would be quite well received by the stock and corporate bond markets, likely resulting in new highs for the major equity indexes.
Admittedly, a few things have to fall into place for such a scenario to play out, but we certainly view it as a viable outcome particularly in light of potential rate cuts in the months ahead. Thus, we believe investors could be well compensated by remaining in the equity and credit markets, although continued volatility will likely be in the cards.
So judging by the pace at which this summer has begun, we would probably expect more fireworks than just your typical Fourth of July festivities. The market is seeking a balance between modest economic uncertainties and favorable Federal Reserve accommodation. While we do not necessarily like what has been causing all of this, we feel the balance currently favors investors, at least those willing to endure a little extra heat between now and football season.
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