Stocks continued a strong rally as optimism grew that trade talks might soon begin to solve the U.S./China tariff war. Yet even with two very strong sessions and signs the rally will continue this morning, stocks remain locked in a rather narrow trading range. As noted previously, the decision to institute the next round of tariffs this weekend will be a binary event. If they go into effect as planned, I would expect stocks to give back at least some of this week’s gains when stocks resume trading after Labor Day. Resumed trade talks or not, more tariffs will serve as a tax on growth. However, should Trump decide to cancel or defer the tariffs at the last minute, certainly something that wouldn’t be out of character, stocks could march higher and challenge record levels. In either case, the fact that both sides now smile, make nice, and offer to talk is far from an agreement. That still appears a long way off. In the end, it will be the tariffs themselves, and not rumors of trade talks, that will impact worldwide economic growth.
It’s easy to get distracted from the economic realities by all the headlines and tweets. The economic realities have been mixed, but the most recent data has actually skewed positive. Employment is still strong, inflation data has stayed consistent, and economic growth is within a normal range approximating 2%. Lower interest rates should help housing. Some make note that refinancing activity has slowed a bit, but with the recent rapid drop in rates, if you were thinking of refinancing, wouldn’t you wait to see if rates were going to move still lower before taking the step to refinance? Once rates stabilize, whether tomorrow or six months from tomorrow, refinancing activity will pick up.
Government spending remains high and consumer confidence continues strong. The areas of weakness and concern remain the same. Capital spending is restrained by the government and tariff uncertainty. Inventories are still too high. Trade is slowing, impacted by tariffs. But these are not the largest parts of the economy. Consumer and government spending together account for over 80% of GDP. In other words, the economic world today is fine with very few signs of slowing significantly. Might it deteriorate further if tariffs keep rising? Of course. But slowing doesn’t mean recession.
The sharp recent decline in interest rates is clearly disruptive to markets. Traders look to the twin bottoms of 2012 and 2016 between 1.3% and 1.4% for ten-year Treasuries and expect a repeat for the third time. Renewed optimism this week has slowed the rate decline, but it is far too early to declare a bottom is near. European rates continue weak and are near record lows. Clearly, they serve as a drag on our rates. This is no historical guide to determine how low rates can go, but it is hard to ascribe current rates to any economic condition. Rather they remain symptomatic of the oversupply condition I keep harping on. Oversupply of money means that the price has to drop. In monetary terms, that means lower rates. It’s no different than lower prices for any other commodity. The cure is more demand, not more supply. The central bank mantra so pervasive today to add even more money simply serves to lower rates further, which in Europe means rates further into negative territory. With that said, low rates are a positive for the valuation of financial assets. All year long, stocks have responded to a combination of lowered earnings expectations dragging prices down and lower interest rates lifting prices up.
Comments from former NY Fed President William Dudley this week questioned whether the Fed should act in a more political way. While the Fed rightfully came out immediately and said politics and monetary policy don’t mix, saying they are a toxic combination, the remarks were damaging to the Federal Reserve’s deserved reputation as an independent agency. While I and most others believe politics has played little or no role in rate decisions to date, in the supercharged world we live in today where virtually every action is viewed as part of a conspiracy, comments like those of Mr. Dudley serve no useful purpose. Thankfully, he received no support from any sitting FOMC member.
That leads us to the next binary event, the FOMC meeting to conclude on September 18. It is highly likely that the Fed will cut rates by 25 basis points. It is also highly likely that President Trump will blast the Fed for not lowering rates further. While our rates remain higher than those of the rest of the world, our growth is higher and so is our rate of inflation. Chasing the expansive policies of Europe will only raise deflationary pressures, hardly a goal sought by lowering rates. If the economy does weaken further over the near term, the Fed can cut rates again in six weeks. That is the proper stance. It would also be proper for the Fed to defer any further cuts after September until December or later if economic data suggests we are growing at a healthy rate with inflation close to 2%. If Trump wants to blame the Fed for slower growth than he wants, that’s his prerogative. Perhaps rates were too high and had an impact on GDP growth rates. Obviously, tariffs were also a growth retardant. No one can tell how much each contributed. The bottom line today, however, is that rates are now falling, and tariffs continue to rise. As long as that continues, growth should continue but at a depressed rate. The Fed is now doing its job to support economic growth. If the President wants to see growth accelerate, he has more weapons at his disposal than the Fed does.
Today, Cameron Diaz is 47. Warren Buffett turns 89.
James M. Meyer, CFA 610-260-2220