Our Top Market Takeaways for the week ending August 2, 2019.

The word on markets

Summertime Madness

Our two favorite market catalysts came to play this week. In the midst of what should be the dog days of summer, both the Federal Reserve and the Trump administration’s trade war with China roiled markets.

First, up: The Fed. Chairman Powell and the rest of the Federal Open Market Committee lowered interest rates for the first time since the Bush Administration on Wednesday. While markets seemed initially disappointed by Chairman Powell’s comments (more on this later), they digested the news by lunchtime on Thursday. Second, in the latest twist in the trade war saga, President Trump tweeted that the United States would place a 10% tariff on the close to $300 billion worth of currently un-tariffed imports from China. This means that there will likely be a tax on almost every good that is shipped from China to the U.S. by September, and the effective U.S. tariff rate on total imports will rise to levels not seen since the early 1970s.

The Fed and trade overshadowed a pretty notable week in U.S. earnings season. Apple’s earnings were lackluster, but the market shrugged it off. Shares rallied, as the company announced it’s expecting $61–$64 billion in revenues for the next quarter, above most analysts’ expectations. Unfortunately, the stock gave up most of its post-earnings gains on the trade news. iPhones are arguably the most high-profile import from China, and until now they’ve avoided tariffs. Healthcare companies Merck, Celgene and Eli Lilly all had impressive earnings reports, and Consumer Staples stalwart Proctor & Gamble reached an all-time high after its release.

By the end of the week, all major global stock markets were in the red. Asian stocks sank, with China’s onshore CSI 300 down -2.9% and Japan’s TOPIX losing -2.4% to finish the week. Heading into Friday, both the Stoxx Europe 600 (-0.8%) and S&P 500 (-2.4%) were lower, suggesting more volatility into the week’s close. The song was the same on a sector level: Defensive sectors Real Estate (+1.3%) and Utilities (+0.2%) saw gains, while those most levered to the business cycle, like Consumer Discretionary (-3.7%), Financials (-3.7%) and Industrials (-2.8%), took the brunt of the decline. Lastly, bond markets mirrored the trend, as U.S. 10-year Treasury yields fell over 20 basis points to 1.85% (the lowest since 2016).

We’ve covered our latest views on the trade war, the Fed, and some things for long-term investors to consider, so we thought we’d leave you with two annotated charts illustrating the summertime madness that the S&P 500 and U.S. 10-year Treasuries experienced this week.

The Fed and trade continue to drive markets Line chart shows S&P 500 Index level for the week of July 29, 2019. The chart highlights major market moves, including Fed announcement, Powell press conference and tariff tweet.

The Fed and trade continue to drive markets Line chart shows U.S. 10-year Treasury yield for the week of July 29, 2019. The chart highlights major market moves, including Fed announcement, Powell press conference and tariff tweet.

Spotlight

A hawkish cut

As we expected, the Fed lowered interest rates on Wednesday. The 25 basis point cut, along with the end of balance sheet run-off, represents the completion of the Fed’s pivot from tightening mode to easing mode. (As a reminder, “easy,” “loose,” “accommodative” or “dovish” policy is designed to stimulate the economy, while “tight,” “restrictive,” or “hawkish” policy is designed to slow it down.) Importantly, Chairman Powell’s post-meeting press conference also jived with our view that this rate cut is designed to “fine tune” policy, rather than mark the beginning of an easing cycle.

We’ve noted that rates markets have been expecting a lot from the Fed, and the initial market reaction gave a taste of what disappointment could look like. Just two weeks ago, markets were suggesting the Fed would lower interest rates by 25 basis points four times over the next year. While the Fed delivered the first on Wednesday, during Powell’s press conference, markets moved briefly to only suggest two additional cuts (i.e., down from four to three in total over the next 12 months). Where did the other cut go?! Well, at the same time, the S&P 500 dropped by almost -2.0%, suggesting that Powell’s remarks were disappointing to stock market investors. All else being equal, lower interest rates should result in higher equity prices (a lower discount rate means that future earnings are more valuable). It seems like markets were grappling with the increased likelihood that interest rates will be higher in the future than they initially assumed.

The Fed not giving markets exactly what they want is kind of like a parent not giving their kid extra cotton candy at the fair.

By the end of the day on Thursday, stocks had recovered most of the decline, and fixed income markets (like U.S. 2-year Treasury yields) were little changed relative to where they were before the announcement (in part because Powell reiterated that the door to more cuts was still open). Going forward, our expectation that the Fed will lower rates once more this year would be a disappointment to markets. Why? Because the market is expecting more cuts (or even more accommodative policy) than we are.

This could be a headwind, but it isn’t all bad news. The Fed not giving markets exactly what they want is kind of like a parent not giving their kid extra cotton candy at the fair. Sure, that extra sugar may lead to an hour or two of fun, but the aftermath could be messy.

Our outlook would disappoint markets Line chart shows fed funds rate from 2015 through 2019, and our 2020 outlook. The line has increased from 2015 through 2019, and our outlook shows the line decreasing slightly.

Of course, it’s hard to disentangle the relationship between trade tensions and the Fed’s next move. Given that the Fed has cited external factors as a reason to lower interest rates, it makes sense that an escalation of trade tensions would nudge it into a more accommodative direction. However, the degree to which the most recent escalation will show up in the data (which is what the Fed is watching) is unclear. At the very least, the escalation in trade tensions makes another cut this year seem all but certain.

It is difficult to overstate the importance of the Fed pivot (January 4, 2019–July 31, 2019). It drove outstanding year-to-date returns across asset classes, and reduced the friction between the cost of capital and expected returns, which ought to support the economy at large. While it is time to start living in the post-pivot world, it seems like trade and the Fed will continue to drive markets.

All market and economic data as of August 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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