Stocks started lower yesterday but recovered most of their losses by session’s end.
Two key events lie in front of us. One is the Chinese trade/tariff discussions. Yesterday both White House economic advisor Larry Kudlow and Treasury Secretary Steven Mnuchin said progress is very encouraging, and a final agreement is still in sight this spring. The second is the two-day FOMC meeting scheduled for completion on March 20th. Hopefully, at that meeting the Fed will give better definition to the ultimate size of its balance sheet. It may also discuss any change in strategy regarding inflation targeting and what measures it may use to both judge and direct future policy moves.
As to the China negotiations, given all the positive vibes coming from Washington lately, the market is presuming that talks will end successfully, and existing Chinese-specific tariffs will be removed once a deal is signed. According to Mr. Mnuchin and Trade Representative Robert Lighthizer, any agreement will have teeth to enforce intellectual property rights and will level the playing field for U.S. corporations looking to do business in China. How tough any agreement might be and how far China may move to open markets remains an open question. Both Presidents Trump and Xi are anxious to sign an agreement and claim victory. To what extent that results in a deal with softer enforcement protocols is an open question. Nonetheless, if an agreement is reached and tariffs are removed, markets will celebrate. Stocks are up 11% this year and 19% since the Christmas Eve lows. So, clearly a lot of good news is already factored in. But that doesn’t preclude some icing on the cake.
As for the Fed, the real questions are less about surrounding tactics and more about the future trend of interest rates and the shape of the yield curve. Given that markets now assume that short term rates won’t be changed at least until mid-year, the short end of the yield curve for Treasuries is anchored in the 2.40-2.55% range. For months, the 2-10 year yield spread has stayed within a very narrow range between 12 and 18 basis points. In English that means the 10-year yields stayed slightly above the 0-5 year range, enough to allay fears that a recession was coming but not enough to suggest growth rates might stop declining any time soon.
But today, that spread is now over 20 basis points. That isn’t exactly a bold move, but it is the largest spread since the Christmas Eve rally began. Yesterday’s release of advanced Q4 GDP data showed growth for all of 2018 was above 3%, and inflation remains below 2%. Widening trade deficits hurt GDP growth while building inventories added to numbers. Widening inventories isn’t exactly the way one wants to derive a healthy number. Nonetheless, there are few signs of any slowdown. The Fed is no longer a headwind, and should trade negotiations lead to the elimination of some tariffs, there is renewed room for optimism.
While we won’t see February employment data until next Friday, there will be a lot of numbers coming today and early next week. While futures point to a strong open today, the data that comes throughout the morning could move markets in either direction.
We are now roughly a year and a half from the 2020 Presidential election. In a reelection campaign, the incumbent President obviously will do all he can to prime the economy for growth through the election cycle. While there are limits to what a President can do, clearly a removal of tariffs, less regulation and expansive fiscal policy are three tools at the President’s disposal. That is why the third year of a Presidential term, particularly in times where an incumbent is seeking reelection, is often good for markets. Markets are already up 11% in the U.S. One should note that they are up at a similar rate in Europe and throughout many emerging markets. China’s markets, which fell sharply last year, are among this year’s best performers.
One quarter doesn’t make a year, and it is quite obvious that stocks aren’t about to rise 11% every two months. Some pause and consolidation at least should be expected. Valuation alone will eventually become a barrier to higher prices. One shouldn’t lose sight of the fact that a 7% gain in January 2018 was followed by a rapid 10% decline in February, and a strong summer rally was abruptly terminated last October. These corrections were more technical than anything else, but they serve almost as a cleansing agent correcting overvaluation states before they get out of hand.
What is interesting to me this time around is that many of the leadership groups in the 2019 rally to date have been very conservative value groups. Utilities, for instance, have been market leaders since the fall. Consumer staples, likewise have been solid performers. This is quite in contrast to early last year when both groups got hit as interest rates rose sharply. If I had to read any message from this, it might be as follows: Growth of close to 4% was unsustainable and is now returning back toward a more normal state, say 2.5%. Temporarily, should all tariff barriers be removed, there could be a brief bump up once again, but any such bump would be a one-time item. At the same time more moderate growth removes inflationary pressure. In recent weeks and months, weekly unemployment claims have started to rise, not to anything alarming, but just enough to suggest that pressures for higher wages could lessen over the coming months. A combination of 2.5% growth and inflation sustained above 1.5% but below 2.0% might not seem earth shattering, but it is almost the perfect formula for stocks. If the 10-year Treasury remains centered well below 3% and trade talks end as market’s expect, there could be further room for upside over the near term. But if growth gets too strong, if the yield curve suddenly steepens, and if 10-year rates cross 3% again, then there could be a correction.
We are also entering March, the most important economic month of the first quarter. Within a few weeks we could begin to see some earnings preannouncement activity. That too could sway markets.
Thus, while we remain optimistic for the year and see modest further gains, the rate of gain won’t match the last two months, and logic suggests a correction or two before year end. But if trade talks end successfully, Presidential cycle trends offer signs of optimism. I wouldn’t suggest chasing the rally, but buying opportunistically might still be successful. One notable lagging group lately has been the financials. Any sign of economic optimism or a widening yield curve will help that group.
Today, Justin Bieber is 25. Javier Bardem turns 50. Ron Howard is 65.
James M. Meyer, CFA 610-260-2220