Published on Feb. 26, 2019
Equity Commentary | January 2019
Stocks rebounded from a difficult end to 2018 with a strong 8% advance in January 2019. Markets were buoyed by a dovish Federal Reserve and positive press reports regarding trade negotiations between the US and China. While we are encouraged by these developments, we think that after this latest run-up much of the good news may now be reflected in current stock prices, and caution that there may be less room for error should fundamentals weaken going forward.
We believe the Federal Reserve’s increasingly dovish stance was a key reason for the stock market gains last month. Key takeaways from the most recent Federal Open Market Committee meeting include a notable change in the press release regarding prospective policy actions from ‘further gradual increases’ to ‘future adjustments’. This is a significant change as it allows for the potential that the next policy move could actually be a rate cut. While we think this is unlikely, the mere suggestion of the possibility marks a meaningful change in tone out of the Fed. As recently as October 2018, Fed Chairman Powell appeared quite confident that the central bank would be steadily raising rates for the foreseeable future.
Moreover, at the press conference accompanying last month’s meeting, Powell noted that rates are presently within what he would consider to be a normal range, giving further credibility to the notion that the Fed is on hold and is unlikely to adjust interest rates higher in the near-term. He also indicated that balance sheet normalization may conclude more quickly and with the Fed ultimately holding more investment securities than previously expected. Moreover, Powell said the process could be adjusted based on economic and financial market conditions, another dovish development in our view.
According to media reports, trade negotiations between the US and China are going well. It appears that most investors now expect that at minimum the March deadline will be extended, if an agreement has not been reached by then. With decelerating global growth being a key risk factor for markets, it is likely that a trade agreement between the US and China could give a significant boost to investor spirits. As well, we think that improving sentiment on the issue in recent weeks was one of the factors helping to lift stocks during January. While the situation remains fluid, we are encouraged that negotiations appear to be moving in the right direction.
There was some mixed economic data out of the US in recent weeks, though we think the results were good enough to calm markets after some very weak December releases. The Institute for Supply Management’s (ISM) manufacturing survey rebounded to a solid 56.5 for January after missing expectations in December. Notably, the new orders sub-index, which weakened considerably in December, bounced back to a healthy 58.2 last month. The labor market continues to look strong with 312,000 jobs created during January, though wages were soft, growing just 0.1% on a month-over-month basis. The Citi Surprise Index, which depicts how economic data points in the aggregate are faring relative to consensus analyst expectations, has moved markedly higher of late. This supports our view that markets were largely pleased with January’s data releases.
In recent weeks, key market indicators including the CBOE volatility index, corporate bond spreads, oil prices, and the yield curve have all shown signs of stabilization or improvement. We are encouraged by these trends, particularly in the aftermath of a very turbulent December for capital markets. These developments, along with a better than feared start to fourth quarter earnings season and improving trade prospects between the US and China, support the bull case that stocks can continue to move higher following January’s strong gains.
Still, key risks remain, and softening global growth may continue to weigh on capital markets. Recent manufacturing surveys in China, Europe, and Japan have been hovering near 50, indicating very slow growth or in some cases contraction. The IMF recently lowered its global growth projections for this year and next, citing weakness in Europe and certain emerging markets, in addition to trade tensions and financial market volatility. As well, while recent domestic data has been better than expected, the current expansion is nearing the longest in US history and we think that as a result investors will be scrutinizing incoming data for any signs of an impending recession. This could lead to choppy markets going forward, particularly with the recent run up in stock prices leaving less room for any deterioration in fundamentals.
We think that a favorable resolution to the China trade war negotiations and improving macroeconomic fundamentals are potential sources of upside, while continued deterioration of macro conditions and a further ramping up of tariffs on China are downside risks. We are also somewhat concerned that damage has been done to consumer confidence and the confidence of business executives, which might take some time to repair. To its credit, however, the Fed has now adopted a view which is more supportive of markets. Therefore while we acknowledge that capital market conditions appear more stable today than even just a month ago, we think sufficient risks remain which leave us with a neutral, balanced view on stocks in the near term.