Stocks finished mixed yesterday recovering from a weak open. The big economic event this week is Fed Chair Jerome Powell’s testimony before Congress today. While it continues tomorrow all the reaction will happen today.
Here’s the conflict. Markets love higher earnings and lower interest rates. That may sound like an oversimplification but it really isn’t. A stock’s price is a capitalization of future cash flows and those are entirely dependent on earnings and a market cap rate tied to interest rates. Thus, markets, at least in the abstract, would love to hear Mr. Powell say that as he views the world today, one should expect 2-4 rate cuts by the Federal Reserve over the next year in an effort to boost inflation to or even slightly above its targeted rate of 2%. Boosting the pace of inflation would also stimulate more growth leading to higher earnings. But Mr. Powell is not an economist. He is not a theoretical person. He is practical and doesn’t want to commit to something he will not be able to live up to down the road. Therefore, while he gets the argument of those who want lower rates, and is probably willing to move in that direction at the next FOMC meeting at the end of July, he will almost certainly not commit to any further actions until some later date.
That doesn’t mean he is in conflict with those seeking lower rates. It doesn’t mean he is in conflict with President Trump’s Twitter rants blasting Fed policy. It means he wants to take one step at a time, examine interim data between now and the next FOMC meeting following the one coming up at the end of July, and make a decision then whether further action is needed.
What will he learn over the next two months that he doesn’t know now? For one, the bond markets, both here and abroad, will move based on the July rate decision here and further actions in Europe. The pace of trade talks with China might change for better or worse. Economic data may show growth stabilization or may indicate further weakening. British elections may firm up a Brexit path. In short, a lot could happen. Or, perhaps, nothing much will happen and the Fed will need to decide if one or two more rate cuts are needed.
Economists within the Fed have paid a lot of attention in recent years to the Phillips Curve, named for economist William Phillips that postulates that decreasing unemployment puts upward pressure on both wages and inflation. That has been debated for decades and has both its supporters and detractors. At best, the linkage based on data is fuzzy. For whatever reason, logical or not, the two are not very well correlated statistically. Proponents of the Phillips Curve were behind the four rate increases in 2018 hoping to stave off pending inflation as the nation approached theoretically full employment. But while wages did start to accelerate in recent years, the pace of wage gains has actually slackened in recent months even as the unemployment rate fell to 3.6%. President Trump, a real estate developer who always loves low rates, has forcefully expressed his own views in his own language. As President he knows low rates should enhance growth, something any incumbent running for reelection would want to see as the campaign begins. But Mr. Powell isn’t going to answer to Trump; he is going to do what he believes is right for the economy long term. He has deep support in Congress. While some suggest Mr. Trump may try at some point to replace Mr. Powell as the head of the Federal Reserve, such a move appears highly unlikely. Legally, he can’t fire him without cause. Replacing him as the head of the Fed but leaving him on the Board may seem like an option but it would be highly disruptive, poorly received in Congress (including Republicans), and could well set off a healthy market correction. As always, watch the action and ignore some of the media blather.
I believe, given the rather muted reaction in markets over the past two days, that markets will be largely content with Mr. Powell’s approach. He will acknowledge that the Fed’s primary goal is to maintain price stability which means inflation of about 2%. He will say that the current inflation rate is too low and action is required to stimulate it. He will also note that cutting rates too far or too fast in a solid growing economy may rob the Fed of tools needed later should the economy fall into recession. That suggests some degree of caution. The Fed listens to markets closely, but markets don’t dictate Fed policy. He may note that further cuts after July are possible if inflation remains persistently low or growth rates erode. That could set up one or two more cuts before year end. But could is different from will. Future action remains data dependent. Markets should understand this.
Switching gears, I note that this week new polling suggests that Mr. Trump’s approval ratings are on the rise and he now stands head-to-head even against all likely Democratic challengers except Joe Biden. That is a substantial improvement over the past six weeks. Why? Perhaps his overseas trip to Britain and the G-20 meeting helped, but the average voter isn’t fixated on tariffs. Rather, I would suggest the big events that helped his improvement were the Democratic debates. Simply said, I believe talk of a vastly expanded and very costly extension of government services from Medicare for all to free public post-high school education scared many Americans. While the Democrats suggested that billionaires would pay for all of this, no one believes that. Americans are swayed by many issues when they vote, but their own financial well being is number one. Many studies have shown that whenever either major political party nominates a candidate too far from the center, they lose. And they lose badly. It is very early in the race and some of the progressive rhetoric will be toned down between now and Election Day next year. But if Democrats want to win, they must win the center. The Democrats did very well in the 2018 House races by nominating strong centrist candidates for contested seats. Maybe nothing is more telling than the decline in popularity of Bernie Sanders, a candidate who appeals to some but scares many. While few, today, expect him to win, the clear message to Democrats is that going too far left is likely to lose more voters than it can gain. There is a long road ahead and, so far, financial markets don’t appear to be reacting to any major pending changes. The ideal would be a spirited race where those in the center can choose the candidate they like the most rather than the one they dislike the least. There is a long way to go and it will be interesting to watch.
Today, Jessica Simpson is 39. Sofia Vergara turns 47.
James M. Meyer, CFA 610-260-2220