The last week’s market highlights:
Quote of the week:
“Since it costs a lot to win, and even more to lose,
You and me bound to spend some time wondrin’ what to choose.
Goes to show, you don’t ever know,
Watch each card you play, and play it slow.”
– The Grateful Dead, “Deal”
You and me bound to spend some time wondrin’ what to choose.
Goes to show, you don’t ever know,
Watch each card you play, and play it slow.”
– The Grateful Dead, “Deal”
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 4Q 2019 Outlook :
- U.S. economy: Still seeing signs of growth
- Global economy: Downward pressure but no recession.
- Policy watch: Markets expect more easing
- Fixed income: Opt for high quality, longer maturity
- Equities: Get defensive, stay invested
- Asset allocation: While cautious, still prefer emerging-market bonds
U.S./China trade: “I heard the news today, oh boy”
So after weeks—or is it months?—of hype, hyperbole and hysteria about the U.S. and China finally sitting down to high-level trade talks, the two sides began negotiations on October 10. Global markets were hoping the discussions would at least result in a tariff “truce,” delaying or cancelling the ones set to go into effect on October 15 (higher rates on $375 billion of Chinese imports) and December 15 (new tariffs on $175 billion more).
But in the week leading up to the meetings, investors confronted a series of potentially sentiment-damaging stories. These included:
- Daryl Morey, the Houston Rockets’ general manager, tweeted support for protestors in Hong Kong, infuriating Chinese officials. (China is a huge market for the N.B.A.)
- The U.S. (1) curbed visas for Chinese officials in retaliation for China’s alleged human rights abuses and (2) blacklisted eight technology companies for their supposed involvement in those abuses.
- The U.S. reportedly reconsidered blocking government pension funds from investing in Chinese stocks and limiting index providers from including Chinese shares.
In response to such headlines, the S&P 500 Index fell 2% over the first two days of the week before clawing back most of those losses on Wednesday and Thursday, as investors apparently began to take a more sanguine view. On Friday, the index rose as much as 1.9% on unconfirmed reports the two sides had reached a small deal that will ease trade tensions, with China agreeing to buy more U.S. agricultural products in exchange for some relief from U.S. tariffs. Then, shortly before U.S. markets closed, Treasury Secretary Steven Mnuchin said the U.S. won’t implement this week’s scheduled tariff hikes. In a classic case of “buy the rumor, sell the news,” the S&P 500 immediately moved lower, finishing Friday off its highs, though still with a 1.1% gain.
Trade may soon take a back seat to the third-quarter U.S. corporate earnings season, which starts in earnest this week. Unfortunately, in contrast to optimism on trade, the news isn’t likely to cheer up investors or propel the S&P 500 out of the 2,800-3,000 range it’s occupied over much of the past two years. (Despite the S&P 500’s 20.4% year-to-date gain, it’s delivered only a 9.9% total return over the two-year period ended October 11, 2019.)
Estimates for third-quarter profits from S&P 500 companies have been declining in recent weeks, a common occurrence before companies start reporting. Analysts tend to low-ball earnings expectations at first, only to raise them over time, thus increasing the likelihood that companies will generate “earnings beats.” So rather than focus on third-quarter numbers, markets will home in on year-over-year growth, which reached just low-single digits in the first and second quarter.
Why the disappointing earnings scorecards? Three reasons. First, the high bar set by last year’s earnings blowout. Second, greater costs courtesy of rising wages and tariffs. Third, weaker revenues, especially from overseas operations due to the slowing global economy and a stronger dollar, which takes a bite out of repatriated profits. And according to Yardeni Research, U.S. blue chips may well struggle to post even modest year-over-year earnings gains in the third quarter. Indeed, Yardeni expects “growth” of -3.2%.
Policy watch: Fed up with U.S./China trade talk? Tune in to the central bank
Last week brought news from the Federal Reserve, with more to come with its next meeting less than three weeks away (October 30).
- A Fed divided can still cut. Minutes from the Fed’s September policy meeting showed that most members of the Federal Open Market Committee—the group within the Federal Reserve that sets monetary policy—backed the 25-basis-point interest-rate reduction. Overall, members believed that household spending would likely remain on “a firm footing, supported by strong labor conditions, rising incomes and accommodative financial conditions.” They also indicated that the housing market was starting to rebound, bolstered by falling mortgage rates. But they were increasingly worried about geopolitical risks, namely the U.S./China trade war, Brexit, and protests in Hong Kong. Persistently low inflation remained on their radar as well. (Headline CPI Inflation fell for the third straight month in September, to 1.73%.)The mixed outlook prompted two policy “hawks” to vote “nay” to September’s rate cut. They noted that the Fed’s economic forecasts had barely changed since the July meeting. Moreover, given the current state of the economy and the Fed’s economic outlook, they believed the current policy stance was “already adequately accommodative.”Fed funds futures, used by traders to bet on the path of interest rates, were little changed immediately following the minutes’ release, still tilted toward more easing. After all, the two dissenters make up a small minority (just two of 10) of the FOMC. But the odds of two further cuts this year tumbled from 64% on October 3 to 28% on October 11 amid renewed hopes for a U.S./China trade deal, coupled with optimism over a Brexit breakthrough. At the same time, the likelihood of the Fed’s holding firm on rates jumped from 4% to 19%.
- The Fed’s gonna get a bigger balance sheet. The minutes also revealed that the Fed delved into a rarely discussed topic: repos. (Repos are transactions that enable broker/dealers, banks and other market participants to borrow and lend to each other to cover short-term needs.) Normally, the repo market operates seamlessly, with more than $2 trillion trading hands every day and interest rates in line with the fed funds rate, currently 1.75%-2.00%. But in mid-September, borrowing costs spiked, hitting 10% in some cases. Demand for cash—from companies making quarterly tax payments and banks settling purchases of U.S. Treasuries—far outstripped supply. (The Federal Reserve’s steady reduction of its massive balance sheet via quantitative tightening from November 2017 through July 2019 reduced the amount of reserves in the financial system.)To bring repo rates back down to earth, the Fed injected more than $500 billion into the repo market via a series of auctions beginning on September 19 while also acknowledging in its meeting minutes that a permanent solution was required. So last Tuesday, Chair Jerome Powell announced that the central bank will “soon” resume purchases of U.S. Treasuries, expanding its balance sheet incrementally to match the market’s need for liquidity.Turns out that “soon” meant three days. On Friday, the Fed said it would begin buying about $60 billion per month in Treasury bills to ensure “ample reserves.” This program will continue at least until the second quarter of 2020. We doubt these purchases will have much market impact, although the Fed’s action is still important. September’s repo ruckus, left unchecked, could have caused short-term lending markets to freeze, triggering widespread fears of a repeat of the 2008 financial crisis, when strains in the repo market were among the first signs of trouble.