Q2 2019 Market and Economic Commentary

by: Richard A. Anderson

Markets had a great first half of the year. Major stock indexes, including the S&P 500, reached new highs. However, global economic growth is slowing. Investor concerns about a recession have increased and unresolved trade negotiations with China have created even more uncertainty. Slowing economic growth, rising recession risk, and tariff uncertainty doesn’t sound like a recipe for a stock and bond rally, does it? So, what has spurred stocks and bonds higher?

Stocks and bonds have benefitted from the growing possibility the Federal Reserve (Fed) will cut rates this year. Fed Chair Jay Powell signaled the potential for a rate cut by saying, “we will act as appropriate to sustain the expansion.” This is a sharp reversal from the Fed’s stance in December of last year, when it seemed determined to raise interest rates as a means to prevent the economy from overheating.

As a reminder, setting short-term interest rates is the primary tool used by the Fed to influence the economy. If economic growth is strong and inflation is above the Fed’s 2% target rate, it would increase interest rates to control spending. If economic growth is weak and inflation is low, as is the case now, the Fed would look to lower rates to stimulate economic growth. Lower rates tend to have a positive effect on the housing market, business investment, and consumer spending because it can be cheap to borrow.

With the U.S. now in its longest economic expansion in its history, the market is hoping Fed rate cuts will keep the bull market and economic expansion alive for a little while longer. At first glance, it doesn’t appear a rate cut is necessary. Unemployment is at 50-year lows, actual GDP for Q1 2019 exceeded expectations, and the stock market is once again at all-time highs. Though, digging a little deeper there are cracks beginning to form in the foundation. Job creation and wage growth are slowing. Inflation is below the Fed’s target and falling. But the biggest threat is ongoing trade negotiations with China.

For these reasons, we believe we will see at least one, but more than likely two, Fed rate cuts before year end. Lower rates could help balance out the negative effects of slowing global growth and prolonged trade negotiations between the U.S. and China. With history as a guide, 81% of rate cuts are followed by a second rate cut within 6 months. Therefore, there is a high probability if the Fed cuts rates in its July meeting it could follow up with a second rate cut in September. However, positive progress towards a trade deal with China following the G20 Summit could help the Fed delay any changes to monetary policy.

There are two questions that we’ve been hearing often in regard to Fed action: can the Fed really cut rates with stocks at all-time highs and how will a rate cut affect the markets? I will address both of those questions separately.

While it might sound counterintuitive for the Fed to cut rates with stocks at all-time highs, it has happened before. In 1995, the Fed cut interest rates with stocks at a new all-time high. In 1989, stocks were only 1% off all-time highs when the Fed cut rates.

How potential rate cuts will affect the markets is a more difficult question to answer. It depends on whether the economy is simply slowing down or if it’s heading into a recession. If the economy is just slowing down and this is a midcycle pause by the Fed, stocks could rally. However, if the Fed’s action is not enough and the economy continues to weaken, stocks could fall.

The chart below shows the performance of the S&P 500 following initial Fed rate cuts dating back to 1984. As you can see, the five initial rate cuts before 2001 saw stocks rally in the subsequent 6 and 12 months. In 2001 and 2007 subsequent stock performance was negative as the rate cuts were immediately followed by a recession and bear market.

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Looking back at history, we believe the environment today is more similar to 1995 or 1998 rather than 2001 or 2007. In both 1995 and 1998, the Fed cut rates after a sustained period of rate hikes as “insurance” against a weakening global economy. In both 1995 and 1998, the U.S. economy responded positively to the Fed’s rate cuts. The Fed’s action resulted in a continuation of the economic expansion and stock bull market.

In summary, we believe a slowdown is the most likely scenario in the near-term. With expectations of the Fed easing monetary policy, this should be accommodative for stocks and riskier assets. However, we will continue to keep an eye on unresolved trade tensions and uncertainty surrounding tariffs, which could be a catalyst for a recession longer term.