MCF Weekly Capital Market Review - August 5th, 2019
As largely anticipated, on Wednesday the Fed cited muted inflation pressures and global developments (weaker global growth and bubbling trade disputes) as reasons to cut interest rates 0.25%.[1] The rest of the release paints a pretty rosy picture of the US economy with strong labor markets and moderate economic growth. So why cut rates? Under Greenspan, The Fed responded similarly in 1995-1996 and in 1998, with what now is known as an “insurance” cut.[2] An insurance cut is used as a cushion to protect the economy against potential weakness, rather than the traditional view of responding to real economic weakness.
Fed Chair Powell appeared to communicate the concept of an insurance cut, noting in the press conference that the cut is a “midcycle adjustment” and not the beginning of a series of rate cuts. A rate-cutting cycle would be in response to “real economic weakness,” explicitly responding, “that’s not what we’re seeing.” [3] Market participants, however, expect multiple rate cuts, not just one. Markets currently are pricing in three more cuts within the next 12 months.[4]
Hints of deteriorating US-China trade negotiations resurfaced when Trump took to social media on Tuesday to state that “China is doing very badly” and alleged that China is backing out again by not purchasing US agricultural products.[5] This comment quietly slipped past market participants, with the focus instead on other politically-motivated jabs. The renegotiation of trade deals was a prominent 2016 campaign promise that Trump has shown every intention of fulfilling, now even more so with the approaching 2020 election.
His comments on Tuesday have substance: China’s second quarter GDP slowed to 6.2%[6] and 40% of Chinese companies that provided guidance this year are forecasting a drop in earnings.[7] China has goals of doubling 2010’s GDP and being a “moderately prosperous society” by 2021. These goals are explicit in China’s current 5-Year Plan[8] and implicit in President Xi’s highly publicized ethos of the “Chinese Dream.” China’s GDP must average 6.2% for the next two years in order to achieve these goals.[9] An escalating trade war with the largest trading partner is a clear economic obstacle.
China’s failure to stop the sale of Fentanyl to the US as one of the reasons for the proposed tariffs. Although this announcement is negative, Trump balanced it out somewhat by stating talks were still constructive, referring to Xi as his friend, and saying that “the future between our two countries will be a very bright one!”
Trade negotiations will likely grab headlines through end of year. Treasury Secretary Mnuchin and his team continue negotiations with China and later this week with Japan. At the G7 summit August 24-26 in France, Trump’s discussions will likely involve the new French tax of 3% on all digital revenues and his response of proposing tariffs on French wine.[1] Trump could even hamstring the World Trade Organization by blocking new judge appointments in December, leaving the body unable to issue appellate decisions.
Equity markets were little surprised by the Fed decision, dropping a little then bouncing back the next day. But they quickly fell and trended downward in response to this new escalation in trade, with emerging markets hit the hardest. The 10-year Treasury yield fell to 1.86% by the end of the week,[2] pushing the widely watched 2-year and 10-year spread closer to inversion. Concerns of a coming slowdown due to further trade tensions pushed oil down almost 8% to below $54 and gold shot up to a 6-year high at $1,450 on Thursday.[3]
Corporate earnings continued to be mixed-to-positive but were overshadowed by the Fed and trade tensions. Indicators last week point to stable consumer spending and employment growth, muted inflation, and muted wage pressures. Consumer confidence roared back well above expectations. Mortgage applications and the Case-Shiller Home Price Index reflect a cooling housing market after large gains for the first half of the year.
This week should be quiet on indicators with reports on ISM non-manufacturing index, PPI, JOLTs, and jobless claims. More important will be next steps from both the US and China in the trade tug of war.
INDEX RETURNS
[2] https://www.bloomberg.com/news/articles/2019-07-24/greenspan-backs-case-for-fed-taking-out-an-insurance-rate-cut
[4] CME FedWatch Tool
[6] https://www.bloomberg.com/news/articles/2019-07-15/china-s-upside-data-surprises-hold-few-reasons-for-optimism
[7] https://www.bloomberg.com/news/articles/2019-07-30/china-s-profit-warnings-signal-more-gloom-for-the-economy
[8] https://www.uscc.gov/sites/default/files/Research/The%2013th%20Five-Year%20Plan_Final_2.14.17_Updated%20%28002%29.pdf
[9] https://www.reuters.com/article/us-china-economy-targets-exclusive/exclusive-china-to-set-lower-gdp-growth-target-of-6-65-percent-in-2019-sources-idUSKCN1P50CJ
[10] https://ustr.gov/countries-regions/china-mongolia-taiwan/peoples-republic-china
IMPORTANT DISCLOSURE INFORMATION
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REFLECTED INDICES
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Bloomberg Barclays High Yield Corporate Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. Investors cannot invest in an index.
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Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed- rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass- through), ABS and CMBS (agency and non-agency). Provided the necessary inclusion rules are met, US Aggregate eligible securities also contribute to the multi-currency Global Aggregate Index and the US universal Index, which includes high yield and emerging markets debt. The US Aggregate Index was created in 1986 with history backfilled to January 1, 1976. Investors cannot invest in an index.
Bloomberg Barclays 1-10 Year US Government Inflation-Linked Bond Index tracks the 1-10-year inflation protected sector of the United States Treasury market. Investors cannot invest in an index.
Bloomberg Barclays US Treasury 1-3 Year Index measures the performance of public obligations of the US Treasury with maturities of 1-3 years, including securities roll up to the US Aggregate, US Universal, and Global Aggregate Indices. Investors cannot invest in an index.
Bloomberg Barclays US Treasury Bellwethers 3 Month Index is an unmanaged index representing the on-the-run (most recently auctioned) US Treasury bill with 3 months’ maturity. Investors cannot invest in an index.