For the week ending August 3
This summary is provided by BMT Wealth Management.
Rate Cut as Expected
The Federal Reserve Bank, and specifically the Federal Open Market Committee (FOMC), was once again center stage last week.
On Wednesday (July 31), the FOMC lowered the federal funds target range by 25 basis points (0.25%) to a range of 2.00-2.25%—as widely expected. This was the first rate cut in more than 10 years.
USA Fed Funds Target Rate (August 2004 – August 2019)
(Shaded Area = Recession)
Source: FactSet, Inc.
We note that there were two FOMC participants who voted against lowering interest rates indicating they didn’t believe there was an urgent need to provide more accommodative monetary policy.
The Fed believes that a rate cut of 25 basis points was justified due to the ongoing risks and uncertainty surrounding the economic outlook. Most notably, in a post meeting news conference, Chairman Jerome Powell referred to both global trade and weak global economic growth as areas of concern, as well as the persistently low inflationary environment. However, the Chairman fell short of indicating that Wednesday’s cut was the beginning of a long regimen of easing moves.
Fed Cut and the Trade Card
Equity markets sold off on Wednesday in the immediate wake of the FOMC announcement, with the S&P 500, DJIA and NASDAQ each ending the day down more than 1.0%. The yield curve flattened, with short-term yields modestly increasing.
In our view, the markets were signaling that the central bank is missing the mark. The bond market is indicating that economic growth is slowing faster than observed and inflation is not an issue, thus sending bond yields lower. It would appear that equity investors were expecting more stimulus.
As Thursday (August 1) dawned, realization of a dovish Fed gained traction and equity markets regained the lost ground of the previous afternoon. However, by mid-afternoon, the market gave back all of its gains, as the Trump administration announced that a 10% tariff would be imposed on an additional $300 billion in products from China. The administration noted that, while talks were progressing, China had not stepped up its promised purchases of U.S. agricultural products, among other concerns.
The sell-off continued Friday, as domestic equity markets registered their worst week of 2019, with S&P 500 Index falling 3.1%. The 10-year U.S. Treasury bond ended the week to yield 1.85%, in further reaction to the tariff news.
The seesaw events and market behavior underscore our message about volatility and late-cycle investing.
The graph below depicts the CBOE VIX which is an indication of the equity market’s expectation for volatility, as calculated using S&P 500 Index options. It is often referred to the market’s “fear gauge.”
CBOE Volatility Index
(Two Years Ended 8/2/19)
Source: FactSet, Inc.
As noted above, the equity market, as measured by the S&P 500 (gold line), has moved higher over the last two years, albeit in an uneven fashion. The VIX (blue line) spiked higher during severe market drawdowns (February 2018 & fourth quarter, 2018), for example.
A key issue worth noting is that during each period of “relative tranquility,” volatility was higher than it was the previous period. We have underscored this issue and believe that this will persist for the following reasons:
- Concerns over peak growth and falling corporate profits
- Tariffs and the trade war between the U.S. and China
- Rising debt at the corporate and governmental levels
- Slowing global growth (Brexit, Italy, China, et al.)
Despite rising equity markets, we have observed divergent trends within asset classes. These divergences underscore the importance of building diversified portfolios that will participate in the rise in asset prices over longer time periods. The issue of risk, as expressed in volatility, has risen consistent with the length of the current economic expansion, as demonstrated above.
We reiterate our call to review asset allocations considering the strong performance, particularly of U.S. equities, and the duration of this economic expansion that has now surpassed the 10-year mark.