Will the Fed disrupt the steady march higher for equities?
SEP. 24, 2018
- Equity indexes are once again at record highs, as we saw a technical breakout and a shift in investor optimism. It will be a challenge to continue that strong momentum this week given trade and Fed uncertainty.
- The FOMC meets on Tuesday and Wednesday of this week and it is almost certain that they will raise rates by 0.25%, as members have been transparent in recent weeks. There is also a high likelihood of an additional hike in December, with the Fed Futures curve embedding an 80% chance. Beyond that, there is a developing debate over the path. The “dot plot” shows that Fed officials are looking for four hikes next year. In recent speeches, some of the more dovish Fed presidents have shifted to a more hawkish tone. Despite the lack of sustained inflation pressure, recent wage gains and a strong backdrop provides cover for the Fed to tighten policy without choking growth. The market may have to adjust to this reality, as the curve only embeds one or two hikes next year.
- Trade discussions have been frustrating, though equity investors have largely ignored them. The White House has signaled the willingness to proceed with a bilateral trade deal with Mexico as discussions with Canada have been frustrating. With China, we are proceeding with tariffs on $200 billion in Chinese goods, with the hint at another $267 billion down the road. The 10% tariff was below the initial guidance for 25%, but it will jump to 25% next year if there is no resolution. Over the weekend, China cancelled trade talks that were scheduled to begin later this week in retaliation. They left open the potential for talks next month, though they prefer to wait for the midterms, which they view as potentially beneficial for their negotiating power. There was word over the weekend that the Trump Administration is planning to accelerate rhetoric on China, including their practices on trade, cyberattacks, election interference and industrial warfare.
While trade uncertainty appears at an extreme level, domestic markets have largely ignored the rhetoric, and international markets have begun to rebound as well. Over the past 10 days, both developed and emerging indexes have rallied 5% despite continued choppy economic data and the dollar at the lowest level since June. Commodity prices, specifically oil, have rallied as well, signaling optimism on global growth.
Following an extended period of curve flattening that had many predicting an inverted yield curve, long-term rates have risen in four straight weeks, with the 10-year yield at 3.07%. The steepening of the curve is a sign that the strong economic growth may sustain longer than previously thought.
Many of the sentiment gauges that were at extremes in January have returned to the highs, including the put/call ratio, demand for low-quality bonds, market momentum and volatility. This may be a sign that we have gone too far, too fast, though the technical breakout and strong participation are good signs. Also, while the S&P 500 18.5x forward earnings in January, it trades at only 16.9x now because of the strong earnings momentum. This is above the historic average, but not extreme.
Existing home sales and new home permits were weak again, with some discussing whether we have seen a peak in the housing market. Prices have been strong, and rising rates has driven affordability to the lowest level since August of 2008.
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