Where to from here?
It has been a roller-coaster few weeks, with the S&P 500 hitting a record high just a week ago Friday, only to suffer a sell-off that stands at 5% and counting. Investors can thank the one-two punch of a less-dovish-than-expected Fed and the threat of new tariffs against China for this new bout of volatility.
While cognizant of emerging risks, the fundamental view of Federated’s equity team hasn’t changed. We continue to stand by our year-end 3,100 target on the S&P, led by our base-case view that monetary stimulus and a slowing but still stable U.S. economy will provide both the earnings and sentiment backdrop for upside by year-end. Getting here from there, however, promises to be a bumpy ride as the two main drivers that have fueled volatility over the past 18 months—the Fed and U.S.-China trade tensions—aren’t likely to quickly resolve themselves.
Let’s start with the Fed. While policymakers last Wednesday delivered the much-anticipated 25 basis-point cut in their benchmark funds rate, Chair Powell was keen to point out that the cut represented a “mid-cycle” adjustment rather than the start of a rate cut cycle, disappointing a market that already had priced in three to four more cuts between now and the end of next year. This was almost immediately followed by President Trump’s decision to announce the imposition of 10% tariffs on an additional $300 billion of Chinese goods effective Sept. 1, with this third tranche of tariffs encompassing a wide array of consumer goods. China quickly retaliated with a competitive devaluation of its yuan to the lowest level in over a decade and the suspension of agricultural commodity purchases from the U.S.
It may be messy for a while
So what do we see going forward? Starting again with the Fed, we fully expect at least another quarter-point cut at its Sept. 17-18 meeting, and possibly a 50 basis-point cut. The rest of the world is in easing mode in the face of decelerating global growth, which threatens to put upward pressure on the dollar leading to potentially tighter financial conditions in the U.S. Additionally, while U.S. labor and consumer data remains remarkably resilient, the yield curve continues to invert further, inflation continues to fall short of the Fed’s target range, falling bond yields seem to be signaling growth concerns, and manufacturing activity has slowed. The upside risk is that global monetary stimulus will not only help global economic data to stabilize and reaccelerate, but will also push down yields to the point where equities are even more attractive.
On the trade front, markets are starting to entertain the possibility that there will be no U.S.-China accord before the 2020 elections. As he looks to secure the U.S.’ standing as the preeminent global power for another generation, Trump almost certainly would view a trade deal with China as his signature economic, security and geopolitical accomplishment and thus is unlikely to cave anytime soon. The question is will the pressure on the Chinese economy force President Xi to give in. That has been our base case view, but it could very well take time, particularly given that China historically has taken however long it must to effect change. The unrest in Hong Kong only acts to further complicate matters.
As if these two headwinds weren’t enough, Brexit looms over an economically struggling Europe. With the ascent of Boris Johnson to prime minister, a no-deal Brexit has gone from a tail risk to our base-case scenario, with the potential for a hard-Brexit on Oct. 31. Despite the long lead-time from the original Brexit vote in the summer of 2016 to a potential exit date later this year, our conversations and analyses indicate the extent to which companies have been prepared for Brexit is quite limited. As such, a hard Brexit could very well provide a shock not only to the British economy, but also to global supply chains and U.K.-European Union trade. While the direct impact to the global economy likely would be minimal, maybe a tenth or two of global GDP, the hit to global confidence could be more severe.
None of this is a big surprise
These aforementioned uncertainties, along with what we viewed as a skewed upside/downside risk, is what prompted the PRISM® asset-allocation committee to pare our equity overweight in Federated’s stock-bond models from 8% to 3% since the end of May. We simply felt there were too many unknowns to be ebullient about stocks, even as we felt comfortable that stocks would continue to outperform other asset classes. This view has thus far been reinforced by earnings, with reasonably good second-quarter results that have earnings-per-share on pace to grow just over 3% on a year-over-year basis. That said, estimates for 2020 may have room to come down, particularly as yet another round of tariffs needs to be accounted for in company guidance. But at this point it looks like an earnings slowdown, not an earnings recession, with the potential for strengthening once we get through this trifecta of worries.
The bottom line: while we believe it may be too early to add to positions as we continue to monitor incoming data, we are on the lookout for that possibility and will keep you apprised. In the meantime, we continue to favor small-cap stocks for their relative insulation from trade woes as well as large-cap growth stocks for their attractive secular growth prospects and, in light of this latest sell-off, valuations.