December 20, 2018

Stocks sagged at the open again today following another interest rate hike by the Federal Reserve (see below). The Dow is currently down 367 pts and the SPX is down 1.5%. This looks like another risk-off day, with cyclical sectors like tech, energy, and consumer discretionary sectors down the most. The utilities sector is up 1% as retail investors look for safety. European markets are down more than 1% and Asian markets were down at least that much overnight. The dollar is weaker today after the Federal Reserve downgraded its outlook for US economic growth (see below). Copper and gold are trading higher, but WTI crude oil fell back to $46.20/barrel. Believe it or not, most of the bond market is trading lower as well. High-grade corporates and junk bonds resumed their slide. Long-term Treasury bonds, however, are moving higher in response to the Fed meeting. The 10-year Treasury note yield is hovering around 2.77%, the lowest level since April.

Yesterday, the Federal Reserve’s Open Market Committee (FOMC) raised its policy interest rate by .25% to 2.5%. Fed Chair Powell managed to strike a somewhat dovish tone while refusing to bow to pressure from President Trump and most of the investment community to pause rate hikes altogether. The Fed’s accompanying statement noted that “some further gradual increases” in interest rates will be needed next year. However, it did acknowledge the need to continue monitoring global developments (i.e. trade war, Brexit) that may pose a risk to the global economy. Mr. Powell referred to these as “crosscurrents.” He said that growth around the world has moderated, financial market volatility has increased, and financial conditions have tightened. These factors, he said, aren’t serious enough to threaten the underlying growth forecast. However, the Fed did lower its outlook for US economic growth. While it noted the economy is currently strong, the official GDP growth projection for 2019 was lowered to 2.3% from 2.6%. The inflation forecast was also reduced to 1.9%. Because of this, the consensus expectation for rate hikes among Fed officials fell from three hikes in 2019, to two. Finally, Mr. Powell reminded us that the Fed’s policy decisions are data-dependent, and not on a pre-set path.

Mr. Powell’s failure to cave to investors’ rather contrived ultimatum—discussed in yesterday’s market update—caused the stock market to throw a temper tantrum in the wake of the announcement. Mr. Powell did acknowledge increased risks from geopolitical issues, but investors are saying he didn’t go far enough. He didn’t put interest rate hikes on hold. The Fed, in its defense, has some good reasons for gradually moving interest rates upward. After 10 years of stimulus, and with the economy in good shape, it’s about time they normalize interest rates. They’ve been very patient and gradual, but if they can’t remove stimulus now, when can they? Most Fed officials would argue the economy no longer needs government life support. And of course, we’ve discussed their desire to reload the monetary policy gun before the next recession.

So capital markets will likely continue to be volatile with the twin overhangs of Fed monetary policy and the trade war. Neither situation is clear at this point. Investors will continue to debate whether trade and the Fed can drive the economy into recession within the next year or two. This is the big question—the only one that really counts. We think that outcome is not likely. And meanwhile, stocks are much cheaper than they were a couple of months ago. The forward P/E ratio on the S&P 500 has fallen back to 14.7, suggesting stocks are cheaper than they’ve been in several years. As long as recession isn’t around the corner, there’s a buying opportunity close at hand.

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