When the Fed speaks, investors listen   

David Joy – Chief Market Strategist, Ameriprise Financial
Weekly markets commentary — June 17, 2019


All eyes will be on the Federal Reserve this week. Expectations are that the Federal Open Market Committee will not take action yet lay the groundwork for lower rates in the meetings to follow, possibly in July or September. Certainly, the bond market has led the way lower, raising expectations that the Fed will follow. Futures indicate just an 18 percent chance of a rate cut this week, but those odds rise to 70 percent in July and 85 percent in September. But it would seem that the Fed can afford to be deliberative. While the latest reports on jobs, the Consumer Price Index (CPI) and consumer sentiment support the case for lower rates, retail sales rebounded in May and the April increase was revised higher. In addition, industrial production exceeded expectations. 

The S&P 500 currently sits just 2 percent below its all-time high. However, its ability to maintain that level of optimism is heavily dependent upon the Fed. It was on Friday, May 3 that the index reached its high of 2945. Just two days later, on Sunday, May 5, president Trump increased the tariffs on Chinese imports and threw the outlook for a negotiated agreement into complete uncertainty. For the next month, stocks fell 6.8 percent. It wasn’t until Fed Chairman Powell’s supportive remarks on June 4 that stocks stabilized and began to climb. Since then the index is higher by 5.2 percent and is within shouting distance of its previous high. 

But the outlook for progress on the trade war with China has not improved. On Sunday, even Commerce Secretary Ross tempered enthusiasm for a meaningful breakthrough at the upcoming G-20 meeting in Japan next week. If that meeting does, indeed, prove to be a disappointment, stocks become increasingly dependent upon the Fed for support in the near-term. 

Corporate earnings and the consumer segment look positive 

That is not the same as saying the economy is necessarily dependent on the Fed in the near-term. Second quarter growth seems to be trending in the vicinity of 2 percent. The consumer sector is healthy and personal consumption appears to have firmed somewhat. And although that is not the same for industries exposed to trade tensions, the expansion seems to be set to continue. 

But whether the pace of activity proves to be sufficient to support expectations for future earnings growth remains to be seen. According to Factset, second quarter earnings are predicted to decline by 2.5 percent. If that were to be the result, it would be the second straight quarter of year-over-year decline, resulting in a so-called earnings recession, albeit a relatively mild one. And since earnings typically exceed expectations, calls for an earnings recession remain premature. But earnings are expected to improve in the second half, with flat growth expected in the third quarter, and 6.8 percent expected in the fourth quarter. Revenue growth is also expected to improve somewhat. For that to be realized, growth will need to be sufficiently supportive, and the damage inflicted by trade tensions will need to be relatively contained, outcomes of which the bond market remains skeptical. 

The Fed has the power to influence near-term direction of markets 

Bond yields generally held steady last week. The two-year note rose just one basis point to 1.85 percent, and the ten-year note was unchanged at 2.08 percent. But both are trading at their lowest levels in at least eighteen months. And the yield curve between the three-month and ten-year maturities remains inverted. And, as with stocks, credit spreads responded to Chairman Powell’s early June comments, having since narrowed by 30 basis points. 

In addition to the Fed’s decision on Wednesday, this week’s domestic economic calendar includes housing starts, permits, and existing home sales, leading indicators and flash PMIs. These reports follow another weak industrial production report from China on Sunday, and a similarly weak industrial production report for the Eurozone at the end of last week. But the tone will be set by the Fed, which has the power to influence the near-term direction of trading.