For the week ending October 25, 2019
This publication is provided by BMT Wealth Management.
Stocks finish the week broadly higher, S&P 500 within 0.1% of an all-time closing high
For the week, the S&P 500 registered a return of just over 1.2%, with notable gains starting and ending the week. The advance on Friday was aided by news that headway had been made on specific trade issues with China.
U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin spoke with China’s Vice Premier on Friday. Afterward, they released a statement saying the two sides were finalizing portions of what would be phase one of the agreement. The reaction in the stock market, to what is perhaps only incremental positive news on the long (very long) unfolding issue of trade, evidences, in our opinion, just how important this matter is to equity investors and the economy in general.
Source: FactSet, Inc.
By the close of trading last week, the S&P 500 was within 0.1% of its all-time closing high registered on July 26, 2019. Encouragingly, advances in the equity markets were broad-based. In fact, smaller cap issues, which have lagged in 2019, registered an advance for the five trading days of 1.9%, as measured by the S&P 600 SmallCap Index. International stocks (MSCI EAFE Index) were higher by 1.3%.
ISM Manufacturing and Manufacturing stocks. As we have highlighted in prior commentary, the ISM Manufacturing Index dropped below 50 during the month of August 2019. A move below that level signals a contraction, and it was the first time we had a contractionary reading in over two years. The Index declined again in the September 2019 release, signaling further deterioration.
Given the decline in the Manufacturing Index, one would arguably expect U.S. Industrial stocks to be struggling, at least if investors expected the trend to continue. In fact, just the opposite is happening. In the chart below, the performance of stocks within the S&P 500 Industrial sector are depicted since 2017. The companies have been equally weighted, as opposed to weighted by size (market capitalization), to remove the outsized impact of the larger constituents (for example Boeing) and provide a look at how the average stock is performing.
Source: Bloomberg, L.P.
As the chart indicates, these stocks are actually starting to break out to the upside and they have been notable outperformers over the past few months. It would be unusual for industrial stocks to be performing so well if it were likely that economic conditions were going to deteriorate over the near term. Stocks generally discount events in the future, often by six to nine months, and the action of Industrial stocks would appear to validate our view that better news is on the horizon for this part of the economy.
What they say, not what they do. The Federal Open Market Committee meets tomorrow and Wednesday, with one final meeting scheduled in 2019 for mid-December. We believe, as do the futures markets, that the Fed will cut interest rates. This would be the third rate cut since they started this process in July 2019. These moves would also reverse the bulk of the action that the Fed took in 2018 to raise interest rates, effectively confirming the contention that at least some of those actions were unneeded.
With a rate cut this week seemingly a foregone conclusion, investors will be paying particular attention to the Fed’s commentary regarding the future direction of monetary policy. Counterintuitively, at this stage of a rate cut cycle, history tells us less is more. Since 1982, we have seen eight instances where the Fed has cut rates at least three times without a rate increase between. The Average S&P 500 performance is far better following the third rate cut when the Fed institutes two or fewer additional cuts. The logic is that if the Fed is compelled to cut more, that usually means the economy is so weak that the Fed is unable to stabilize growth – 2001 and 2007 are the two most recent examples.
Source: Strategas Research Partners
Employment metrics coming this Friday. The backbone of the U.S. economic expansion has been U.S. consumer spending, which has been supported by multi-decade low unemployment rates and modest wage gains. With business investment at muted levels due to concerns on trade, it is imperative that a positive backdrop on the employment front continues to be in place. This Friday at 8:30 a.m., the statistics for the month of October 2019 will arrive, with the release of data on monthly jobs gains, wage gains, and the unemployment rate. Current indicators point to the likelihood of continued positive news with respect to the U.S. consumer.
Yield curve no longer inverted. Earlier this year, financial markets obsessed over the inversion (short rates above longer-term rates) of the U.S. Treasury yield curve. Yield curve inversions are typically a signal that investors are expecting significantly slower economic growth – during an inversion, investors prefer to lock in a longer maturity bond even if shorter maturities are yielding more. If one expects materially slower growth, they risk having to reinvest that shorter maturity bond at lower interest rates…. ultimately making them worse-off.
The yield curve has always inverted prior to a recession, but the timing between inversion and recession is extremely unpredictable. Furthermore, one might argue that the longer end of the U.S. Treasury curve has been distorted by global interest rates. With the German 10-year bund currently yielding -0.35% compared to a U.S. 10-year government bond of 1.83%, it is no surprise that foreign buyers have been attracted to U.S. debt. This dynamic has increased demand for longer-dated U.S. bonds, pushing Treasury prices up and yields artificially down. The short end of the U.S. yield curve was pushed up by interest rate increases from the Fed, with the final hike in the tightening cycle happening in December 2018. The resulting inverted yield curve was a primary data point for those predicting an economic contraction and significant market selloff.
As the Fed likely engages in its third rate cut of 2019 later this week, the curve has “uninverted.” This additional action from the Fed should further steepen the curve, alleviating concerns of an imminent recession as economic data marginally improves in early 2020.