Next Week’s FOMC Meeting
Last week we revised our monetary policy forecast to a 50% chance that the Fed would either initiate a fed funds rate cut, put an end to balance sheet normalization or both at their June 18-19 meeting. Had President Trump placed tariffs on Mexican imports this week, the chance of a rate cut would have grown to 75%; but tariffs have not been imposed on Mexico and therefore we believe the odds of a monetary policy change are breakeven this month. Note that our change in view has less to do with tariff-wars than it does with the fact that US inflation has been below the Fed’s target of 2% and likely to trend lower, sovereign bond yields are near record lows in most developed countries and the deceleration seen in several segments of the US economy since late 2018 has been a concern. These same trends will be examined by the FOMC next week and whether monetary policy is changed or not, we expect the Fed’s statement and Chairman Powell’s comments to be accommodating and soothing to the markets.
In Response to Falling Consensus Estimates
We have noticed that many economists are lowering their GDP forecasts for 2019 and strategists are subsequently lowering earnings estimates and SPX targets. Since first quarter earnings results were better than originally expected, we assume this is linked to angst regarding tariffs and pressures on global trade. However, we believe GDP reductions are an emotional reaction to the escalating rhetoric of President Trump and the news media’s negative response, rather than an unbiased view of domestic economic trends. There are pockets of weaknesses in the US economy such as auto and housing sales, but these are cyclical trends and not related to tariffs or fears of tariffs and are a key reason the Fed is apt to be more accommodating this year. Therefore, we look at the factors that may lead to a rate cut next week, as well as a collection of improving technical indicators. Overall, little has changed in our view. We expect the equity market to be rangebound for the next few months and our SPX 3110 target for this year is unchanged.
It Is All About Jobs
May’s payroll gains of 75,000 were well below consensus expectations and revisions to March and April’s reports subtracted another 75,000 jobs. Most industries showed incremental job increases, but the retail sector reported declines in line with previously announced store closures. May’s report also had factors that make results difficult to analyze such as the end of the school year and an early Memorial Day, both of which would have an impact on industries such as leisure and hospitality. But overall the results were poor. Our favorite job indicator is the year-over-year job growth in both surveys and in May, the establishment survey showed a 1.58% YOY gain and the household survey had a 0.78% YOY increase. Both surveys have been growing at rates below their long-term averages of 1.77% and 1.5% YOY, respectively, for four months. See page 3. In sum, the weakness in the job market is not new. In fact, the typical rebound in employment seen after a recession never appeared in 2009 and consequently job gains have been below average this entire cycle. We indexed employment growth to the peaks and the troughs of the last ten economic cycles and found that the current expansion ranks near the bottom of all cycles in terms of job growth. See page 4. In short, the economy is all about jobs. The one consolation to this sluggish growth rate is that the combination of nominal wage gains and low inflation have produced a fairly good environment for the average worker. Real hourly earnings and real weekly earnings grew 1.75% and 1.1%, respectively, in May; both are above their long-term averages. See page 5.
The ISM manufacturing index disappointed in May, falling from 52.8 to 52.1 for its second consecutive decline. The index averaged 55.4 in the first quarter and 56.9 in the fourth quarter of 2018 and is currently the weakest since the third quarter of 2016. However, the ISM nonmanufacturing survey index jumped 1.4 points to 56.9 in May. This demonstrates growth in the nonmanufacturing sector, which accounts for roughly 88% of the economy. The details were largely supportive with business activity rising 1.7 points, new orders increasing 0.5 point and employment jumping 4.4 points. Most importantly, the employment index jumped from 53.7 in April to 58.1 in May and twelve industries reported an increase in employment. Only mining, agriculture and information reported declines. See page 6. The ISM Manufacturing index has historically been a precursor of SPX earnings and price performance; however, while SPX earnings growth has decelerated along with the ISM index, the SPX price index has more than compensated for this. Still, this suggests earnings growth will be critical to the SPX’s performance in the second half. This is not a surprise. See page 7.
The NFIB Small Business Optimism Index posted a 1.5 point gain to 105.0 in May. Expectations for sales, business conditions, and expansion all advanced strongly. The inventory imbalance of April was resolved, and owners plan a modest build in stocks. Earnings trends remained very strong and credit conditions very favorable. Uncertainty levels remain high, but owners are focused on a very busy Main Street. Business optimism should move higher in June now that Mexican tariffs have been resolved. See page 8.
Trade and Tariffs
Trade data for April was just released and it shows that on an annualized basis, total US exports fell 2.1% and total imports declined 4.7% year-to-date. The trade deficit as a percentage of GDP fell from 2018’s year-end level of 4.3% to 3.8% (annualized) in April. Chinese imports were down 21.8% and exports to China were down 15.4% in the first four months of the year (annualized) and this reduced the trade deficit between US and China by 23.6%. Economists may be missing the potential impact this shift in trade could have on GDP going forward. China’s trade deficit with the US had a negative impact on nominal GDP of 2.1% in 2018 and this fell to a negative 1.52% as of April. See page 9. And despite the news media’s focus on the negative impact Chinese tariffs will have on US consumers, as of April, import prices were down 0.2% YOY and import prices excluding petroleum products were down 1.0% YOY. Export prices rose 0.3% YOY in April. But this is not the only trend that suggests inflation is low and trending lower. The price of crude oil is down 20% YOY and this has led to the modest 1.0% YOY increase in the PPI of finished goods and 1.9% YOY for final demand reported for May. See page 10. Therefore, with inflation benchmarks below the Fed’s 2% target and import and energy prices falling, inflation is expected to trend lower in 2019. Since the Fed’s mandate is to maintain strong employment while maintaining modest inflation, it is easy to see why the Fed is more likely to cut than raise rates in 2019.
Technical Indicators Improve
The Russell 2000 (RUT – 1519.11) index remains on our watch list since it is still trading below all its moving averages which are now clustered in a tight band between 1542 and 1551. However, the other popular indices are trading above their 200-day MAs which we noted last week was important resistance. This is positive, but it would be more impressive if the RUT did the same. See page 14. Our favorite 25-day up/down volume oscillator is rebounding after nearing, but never entering oversold territory. This is classic bull market action during a correction. See page 15. The notable indicator this week is the NYSE advance decline line which recorded a record high this week and is therefore outperforming the popular indices. See page 16. AAII bullish sentiment fell to 22.5% and bearish sentiment rose to 42.6% this week which is a favorable combination and adds to the positive tilt in the technical indicators this week.
“Overweight”: Overweight relative to S&P Index weighting
“Neutral”: Neutral relative to S&P Index weighting
“Underweight”: Underweight relative to S&P Index weighting
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