July Looks Like a Done Deal
For the most part it was a quiet summer week in the markets. Really the highlight (other than a great stage 6 at the Tour de France) was Chairman Powell’s testimony on Wednesday and Thursday in front of Congress. Over the last few weeks the market had moved strongly to price in rate cuts from the Fed in the second half of this year. If he was going to signal that the market had gone too far this was his opportunity.
Turns out he did nothing of the sort. He noted that despite a strong jobs report for the month of June and last month’s new truce in the trade war between the US and China, “uncertainties about the outlook have increased in recent months”, particularly internationally.
“Economic momentum appears to have slowed in some major foreign economies, and that weakness could affect the US economy. Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit. And there is a risk that weak inflation will be even more persistent than we currently anticipate.”
This was taken as an indication that the Fed will cut rates when they meet July 30th and 31st. A quarter point cut is most likely. Currently the market is assigning odds of 77% to a quarter-point cut and just 23% to a half-point cut.
Powell’s comments were then backed up by the minutes from the Fed’s June policy meeting. These painted a similarly “dovish” message. Key points:
– Officials grew more concerned about the economic outlook last month and discussed reasons why lower interest rates might be warranted in the coming months.
– While they voted to hold rates steady, many officials were ready to cut rates ‘if an economic outlook clouded by slower global growth, weaker-than-expected inflation and uncertainty over trade tensions didn’t soon improve.’
Looking out to December, the odds of rate cuts are as follows:
¼ Point Cut 10%
½ Point Cut 34%
¾ Point Cut 37%
Full Point Cut 17%
>Full Point Cut 2%
So far this sure seems aggressive, especially with this week’s hotter than expected CPI report. What would it take to garner large rate cuts? Here are three ideas:
1) European banking crisis. The chart below shows the share prices for Deutsche Bank and Credit Suisse. Yes, they are about at the lowest they have ever been. There are a number of factors at play, but negative rates in Europe sure are not helping their business models. With the ECB likely to cut rates even deeper into negative territory later this month, you wonder how the banks emerge unscathed. The Fed is clearly tuned into weakness overseas. This is an emerging candidate over and above the trade issues.
2) While this week’s CPI report was a touch hotter than expected, there is still a case to be made for lower inflation over the next few months. As BCA notes,
“The good news is that this is unlikely to happen any time soon. While wage growth has picked up, productivity growth has risen even more. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (see chart below).”
Downside surprises in inflation could induce the Fed to cut by more than 25bps/50bps in the months to come.
3) The trade war expands. Trump went after India this week. European auto makers are still on the list.
Of course there are other factors that could influence policy. But we are clearly moving into a period where policy makers are going to lean in the direction of accommodation. The next major event in this regard will be the European Central Bank meeting July 24-25.
Are Investors Overly Pessimistic on Earnings?
Next week second quarter earnings reports start to filter out. Charles Schwab and Citigroup are on deck Monday followed by JPMorgan, Wells Fargo, and Johnson and Johnson Tuesday. Expectations for this round of earnings are subdued. Analysts see S&P 500 earnings declining by -2.8% with sizable falls in both the tech and materials sectors, as you can see below.
While earnings are expected to be down, sales expectations are more optimistic at +3.7% year-over-year.
Full year earnings expectations are for growth of just +2.0%. This is down dramatically from just a few months ago when analysts thought we’d see growth of close to +12.0% in the U.S, as you can see below.
Of course, all of this is in the price of the market (it is consensus expectations after all). The question is which way will the expectations be wrong?
Layer on top of this investor positioning. Last week we saw the 4th largest outflow from equity mutual funds and ETFs in over a decade – roughly $28 billion.
On a trailing 6-month basis the dollar outflows are the largest ever (note – this isn’t the case as a percent of AUM).
This sets up an interesting dynamic. The bar is pretty low for corporate America on the earnings front. Modestly better numbers, the so called ‘upside surprise,’ would be warmly welcomed by equity investors who have been acting like they are bearish on the markets. We will find out much more next week.
Have a good weekend.
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