Stocks hit record highs during October, as optimism grew that the US and China were progressing towards the first phase of a trade agreement, and economic data firmed. Investors were also encouraged by the Federal Reserve, which cut interest rates and signaled that monetary policy will likely remain stimulative for the foreseeable future.
There was some progress on the trade front during October. The Trump administration held off on a planned tariff hike on Chinese imports as the two countries moved closer to reaching an agreement in principle on a phase I trade deal. In exchange for tariff relief, China is expected to significantly increase its purchases of US agricultural products and will also accelerate the opening of its finance sector. While the deal still needs to be signed and formalized, we view this preliminary agreement as a positive indication, and it was likely a key factor in boosting stocks during October. However, we think that this is only a first step, and that much work needs to be done in order to resolve thornier issues such as intellectual property protections. Moreover, we think it is unlikely that any substantial progress will be made beyond this phase I of the trade agreement until after the US elections next November.
Following a lackluster 3rd quarter for economic growth, there are reasons to believe that fundamentals may be improving. The Institute for Supply Management’s (ISM) October non-manufacturing survey came in ahead of expectations and marked an improvement from September’s reading. Consumer confidence remains at healthy levels and the housing market continues to strengthen. The latest reading on the labor market was also encouraging, as the 128,000 jobs created during October exceeded investor expectations despite being dragged down by the GM strike. Further confirming these green shoots are market indicators such as the yield curve which has steepened meaningfully of late. Perhaps as a result of these positive trends, many of the economic forecasts that we track have lowered their near-term recession probabilities from approximately 50% just a couple of months ago, to 25% today.
We think that corporate earnings have also given investors reasons for optimism. Profits were expected to fall sequentially for the 3rd quarter, but aggregate earnings have exceeded forecasts to the extent that it now appears they will show positive growth on a quarter-over-quarter basis. Perhaps even more importantly, forward earnings estimates for the S&P 500 have been moving higher. While certain sectors, such as energy and manufacturing remain challenged, we believe that these issues have been contained and do not appear to be dragging down the broader economy.
As was widely expected, the Federal Reserve cut interest rates by 25 basis points at its October meeting. The FOMC (Federal Open Market Committee) signaled in its prepared statement that it expects to be on hold with regards to further interest rate moves for the foreseeable future. This marked a notable change, as prior to this the Fed had been preparing investors for further rate reductions. The central bank suggested its policy stance is appropriate for as long as its baseline views about growth and inflation remain intact, which we believe creates a high bar for the next policy shift. What is most significant in our view is that the Fed funds rate is currently below the inflation rate, or put another way, real interest rates are negative. Negative real rates tend to be a stimulative factor for the economy, so while the Fed may be on hold for the time being, monetary policy remains quite accommodative and will likely continue to be so for an extended period. The central bank has also resumed its balance sheet expansion, which on the margin should provide additional stimulus. We think that it was this confluence of improving economic data, thawing trade tensions with China, and a supportive Federal Reserve which has buoyed investor spirits and helped propel stocks to record highs during October.
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