3rd Quarter Market Commentary – The Fed Speaks

October 11th, 2019 by Jonathan Chatfield, CFA

Against the backdrop of an intensified trade dispute with China and a softening economy, the Fed lowered its federal funds rate target by another quarter point at its September 18 meeting. The target rate now stands at 1.75 – 2.0 percent. After raising rates nine times since 2015, the Fed reversed course this year and has now cut rates twice in an era of modest inflation and full employment. The key inflation rate, the Consumer Price Index excluding Food and Energy, is up 2.4% for the 12 months ended September 2019. Meanwhile the unemployment rate hit a 50-year low of 3.5% in September as payrolls increased by 136,000. The Fed’s mandate is to foster maximum employment and price stability. In a slowing economy the rate cuts should provide stimulus and moderate any economic downturn.

Slowing Global Growth
For the second quarter U.S. GDP growth moderated to 2.0% after posting 3.1% growth in the first quarter. Global GDP, meanwhile is forecast by the IMF at 3.2% in 2019, down from 3.6% in 2018, with a rise back up to 3.5% in 2020. In response to the slowdown, central banks around the globe have lowered interest rates to stimulate economies. Negative rates in Europe and Asia have spurred demand for higher-yielding US treasuries, which has factored into the current elevated prices of bonds (lower yields) and contributed to the yield curve inversion.

Inverted yield curve
The 10-year Treasury yield has been below the 3-month since May, a condition that many view as a predictor of a recession. While recession fears cause market participants to evaluate their level of equity investment, research this year from noted economists Eugene Fama and Kenneth French found no evidence that an inverted yield curve predict stocks will underperform Treasury bills. 1

Forward 12 month EPS estimates for the S&P 500 have declined over the past month, falling 0.57% from $176.75 to $159.83 as analysts revise their estimates in the slowing economic environment. Further reductions in earnings estimates could pressure stock prices.

Anchor Bay investment strategy
At this time of slowing economic growth, downward revisions to earnings estimates, the unresolved trade dispute with China and a potential recession on the horizon, we continue to proceed with caution. We are in the late stages of the economic cycle and stocks, after recovering from a sharp decline in late July/early August, are again priced near record levels. We have adjusted the portfolios and cut back on our equity exposure, increasing exposure to defensive sectors, in light of the risk of economic slowdown and resulting earnings pressure on stocks.
Investment grade corporate bonds and U.S. Treasury bonds, meanwhile, trade at elevated price levels and offer very little in the way of yield. Due to the risks in the market, we are maintaining over-weighted positions in money markets and short term Treasury securities.

While we are optimistic low interest rates will provide economic stimulus, we believe it is prudent in the current environment to maintain a reduced exposure to equities and wait for indicators and events, particularly a resolution to the trade dispute with China, to give us the next signal.

Stay tuned…

1 “Inverted Yield Curves and Expected Stock Returns”, E. Fama and K. French, July 28, 2019, https://famafrench.dimensional.com/media/467645/inverted-yield-curves-and-expected-stock-returns-july-28-2019.pdf