Taking some equity chips off the table
The S&P 500 just completed its strongest June in 64 years, surging 6.8% this past month (compared with an 8.2% increase in June 1955) and hitting a new record high last week at 2,964. This month’s rally effectively reverses the 7.6% decline that stocks suffered during May, when investors reacted negatively to the apparent breakdown in the trade-and-tariff negotiations between the U.S. and China. Stocks have now risen by nearly 26% from last year’s Christmas Eve low.
But as we look across the proverbial valley, we see a heightened chance of increased risk and volatility during the summer and early fall months due to several developing domestic and international issues. Consequently, with stocks now sitting just off an all-time record high and with our near-term risk/reward ratio certainly less attractive than it was last Christmas Eve or even last month, we thought it prudent to lock in some profits and take some chips off the table.
So Federated’s PRISM® asset allocation committee held an ad hoc meeting today, in which we decided to reduce our equity overweight from 5% to 3%—30% of our maximum overweight in stocks. To achieve this, we cut our domestic large-cap value allocation a tick to a neutral 15% and lowered our international developed allocation a tick to a neutral 10%. We added this 2% to cash, which is now flush with an overweight 8% allocation versus a neutral 2%, because it provides us with the flexibility to reallocate quickly to the equity market at potentially better prices later this year.
Why have we turned more cautious? At the conclusion of last week’s policy-setting meeting, the Federal Reserve left interest rates unchanged, as we had expected. But the financial markets have priced in with 100% certainty that the Fed will begin a new rate-cutting cycle at its upcoming July 30-31 meeting, with the only decision being whether to cut rates by 25 or 50 basis points. We’re uncomfortable with that consensus outlook as we believe that the Fed’s decision next month will be much more data-dependent, with the potential for financial-market disappointment if the Fed opts to stand pat.
What’s on the Fed’s checklist? In our view, these are the key issues that the central bank will study over the next month before independently arriving at a decision:
- Core PCE inflation for May was reported this morning at a higher-than-expected increase of 1.6% year-over-year (y/y), unchanged from April and up from 1.5% in March. In our view, inflation is relatively benign and stable, not decelerating into a deflationary or disinflationary glide path.
- The G-20 meeting in Osaka, Japan began yesterday, and Presidents Trump and Xi are scheduled to hold a private meeting tomorrow. We’re expecting a cordial meeting between the U.S. and Chinese leaders, which should help to jumpstart critically important negotiations.
- ADP private employment report for June will be flashed on Wednesday, July 3, with an estimated gain of 138,000 jobs versus only 27,000 in May.
- June nonfarm payrolls will be reported next Friday, July 5, and we’re expecting a rebound of 165,000 jobs over disappointing May results of only 75,000. The survey week for the initial weekly jobless claims were reported at 217,000, just off April’s 49-year low of 193,000.
- June core CPI and PPI inflation will be flashed on July 11-12, and we’re expecting flattish results of 2.0% and 2.3% (y/y), respectively
- Second-quarter 2019 earnings season starts on July 16, with consensus expectations for a y/y decline of 2-3%. We’re expecting slightly positive results, but management guidance will be very important.
- Second-quarter 2019 GDP and annual benchmark revisions will be flashed on Friday, July 26. We’re expecting GDP to rise at 2.3% annualized rate, versus consensus expectations for a 1.9% increase, due to solid consumer spending.
International risks Halloween is coming, and with it, several global concerns:
- UK’s Brexit deadline was moved from March 31 to Oct. 31, and a hard Brexit outcome under a new—and as-of-now unknown—prime minister is becoming more likely
- Mario Draghi’s 8-year term as the head of the European Central Bank expires on Halloween, with no named successor as yet
- No final decision has been made on Japan’s proposed VAT increase from 8% to 10%, but it would take effect on Halloween. The last two VAT increases resulted in recessions.
Could stocks grind lower this summer and fall? If the Fed’s checklist proves largely positive over the next month, policymakers may decide not to cut rates again on July 31, pushing that decision out to their next meeting on Sept. 18, which could result in a choppy August and September for stocks. Moreover, the aforementioned international developments could extend that correction into October. While our longer-term view on stocks remains constructive, with an S&P target price of 3,100 by year-end, the combination of near-term domestic and international worries could provide us with a better re-entry point later this year.