Big Things in October. What Next?

By Paul Hoffmeister, Chief Economist

November 7, 2019

As we stated last month, important news about US-China trade, Brexit, and the Fed was due in October that had the potential to move markets significantly. The good news is, markets received positive information concerning these variables, sparking a strong stock market rally during the month.

On October 11, it appeared that the US and China had agreed to what was dubbed a “phase one trade deal”. According to President Trump, the Chinese government agreed to increase purchases of US agricultural commodities, certain intellectual-property measures and concessions related to financial services and currency.[i] In exchange, an increase in tariffs on Chinese imports was delayed.

Then, on October 17, European Commission President Jean-Claude Juncker tweeted, after heated negotiations with Prime Minister Boris Johnson over Brexit: “We have [a deal]! It’s a fair and balanced agreement for the EU and the UK to our commitment.”[ii] While the deal did not ultimately receive approval from the British Parliament, it appeared to have reduced the odds of a no-deal Brexit in the future. Underscoring the importance of the perceived breakthrough in this variable, the British pound rallied in October from a low around 1.22 dollars per pound to a high of nearly 1.30 – an especially large swing in one of the world’s largest currencies.[iii] Nonetheless, the Brexit issue is not yet resolved completely. The UK will hold a general election on December 12, meaning that the question of Brexit and its specific outlines will be left to the voters once again.

Finally, on October 30th, the Federal Open Market Committee announced an interest rate cut for the third time this year, nearly reversing its four rate increases in 2018. Note, the three rate cuts so far this year is a vastly different scenario than what FOMC officials were telegraphing late last year for 2019, when they contemplated two to three rate INCREASES. As such, the federal funds rate now trades at a range between 1.50% and 1.75%, as opposed to what was possibly going to be 3.00%-3.25% today.

While Fed policymakers recently expressed concerns about slowing global growth and uncertainties surrounding trade and Brexit, there also appeared to be a major change in their perspective about the general price level, from fear in 2018 of inflation to a fear today of unacceptably low inflation. The Fed is now, importantly, more accommodative and arguably more in-line with what equity markets want or expect.

As we see it, the confluence of positive news on trade, Brexit and Fed policy ultimately translated into a more than 5% rally in the S&P 500 in October -- when measuring between its October 2nd closing low of 2887.61 and its close of 3037.56 at month-end.[iv]

The major macro developments of recent weeks also appear to have relieved the concerns seemingly priced into credit markets, as the US Treasury curve significantly steepened out of the inversion we saw during the late summer.

After reaching a low of nearly -50 basis points in late August, the spread between 3-month and 10-year Treasuries is now nearly +30 basis points.[v] As readers know from our writings in recent years, the almost persistent flattening and then inverting of the Treasury curve during 2018 and 2019 was increasing the odds of a future recession based on the New York Federal Reserve’s yield curve/recession model. The major steepening in recent months has alleviated the concern over an imminent recession.

With many fears and uncertainties sorted out during the last month, we can breathe a sigh of relief, at least for now. The Fed is no longer trying to slow growth with interest rate increases; there’s less fear about the UK crashing out of the European Union; and relations between Washington and Beijing are, at least, still constructive.

Notwithstanding, there are still important questions and potential dangers ahead.

The questions at the top of my mind are the following: At what point will the Fed no longer be accommodative? What happens to US-China relations after any phase 1 trade deal is signed? Will the British voters give Boris Johnson a clear mandate on December 12 to complete the Brexit deal he has negotiated? Does the Trump impeachment push have any legs to it? Who will win the 2020 presidential election, and what will that mean for future US economic and foreign policies?

The Fed: The last time the Fed made a “mid-cycle” adjustment (if in fact we are in a mid-cycle adjustment phase today) was in September 1998 when it started to cut the fed funds rate from 5.50% to 4.75% in November 1998. Those rate cuts seemed to prop up stock prices and steepen the yield curve, similar to this year’s cuts. It’s noteworthy, however, that the Fed then reversed course and restarted its rate-hiking campaign by June 1999, raising the funds rate from 4.75% to 6.50% by May 2000. If that episode is analogous to today, then the Fed’s present dovish policy posture may be short-lived, perhaps only six to nine months. With many of today’s Fed policymakers concerned in recent years about low unemployment creating inflation risks and stock market highs creating investment bubbles, it will be important to note whether those views re-emerge in the coming months.

But, for now, the Fed policy outlook appears favorable. As Chairman Powell said during his October 30 press conference: “The reason why we raise interest rates, generally, is because we see inflation as moving up, or in danger of moving up significantly, and we really don’t see that now.”[vi]

US-China Trade: In recent days, rumors have emerged that the signing of the phase one deal could be delayed to December. According to Reuters, Beijing wants Washington to drop the 15% tariffs on $125 billion worth of Chinese goods that went into effect on September 1, AS WELL AS a reduction in the 25% tariffs imposed on approximately $250 billion of imports including semiconductors, machinery and furniture.[vii] Reportedly, the White House wants strong language in an agreement related to enforcement mechanisms related to intellectual property theft.

As I see it, this is last minute horse-trading where the important details of the phase one deal will be worked out. Given that the phase one deal is only a partial one and doesn’t touch on other major areas of disagreement (such as Chinese subsidies to state-owned enterprises and easing controls over the internet), it’s unlikely that the White House will roll back most of its tariffs. Arguably, the main leverage that the White House wields in the negotiations are tariffs and black-listing major Chinese companies from doing business in the United States. But, at the moment, it’s likely that a sufficient number of tariffs will be rescinded, and a partial deal will still be reached.

Nonetheless, there is still a long way to go in the trade dispute between the US and China. Quite possibly, this will go on for many years. The issues in the phase one deal could be the easiest issues to resolve.

UK Elections & Brexit: According to a YouGov survey between October 17 and 28, Boris Johnson’s Conservative Party leads with 36% of voters, then Labour with 22%, Liberal Democrats 19%, and Brexit 12%.[viii] Consequently, the December 12 general election looks like Johnson’s to lose. If the Tory’s give up that lead to Labour and Liberal Democrats, then Brexit may not happen anytime soon. Conversely, if Tory’s give up the lead to the Brexit Party, we could see another stalemate with the EU, as the future government will be pressured to be even more aggressive in negotiating another deal.

Trump Impeachment: On October 31, the House passed a more formal process related to impeachment. In the weeks ahead, six different House committees will continue their investigations into the Trump Administration, which will include public hearings as well as closed-door depositions. The first public hearings will be held during the week of November 11.

Predicit betting markets are currently pricing in a 40% probability of a Trump impeachment by year-end 2019, and 78% probability by the end of his first term.

Perhaps the most important aspect to a possible impeachment will be whether Republican senators stay united in their opposition against the removal of the President. Notably, on November 5th, Senate Majority Leader Mitch McConnell said, “I’m pretty sure how [an impeachment trial] is likely to end. If it were today, I don’t think there’s any question, it would not lead to a removal.”[ix]

If we see Republican senators begin to support impeachment and voting to remove President Trump, the S&P 500 could be vulnerable to a significant decline.

As we’ve pointed out before, we believe the events leading up to President Clinton’s impeachment contributed to a nearly 15% selloff in the S&P 500, specifically between the time of the Lewinsky plea deal and the release of the Starr Report when the clouds were arguably the darkest for Clinton. With regard to President Nixon’s impeachment and ultimate resignation, between November 1, 1973 when Leon Jaworski was appointed special prosecutor and August 8, 1974 when Nixon resigned, the S&P 500 fell approximately 25%.

At the moment, it seems that markets are not overly concerned about the prospect of a Trump removal. If that changes, we could see major equity market weakness.   

2020 Presidential Election: According to Predictit betting markets, Senator Warren’s chances of winning the Democratic nomination have fallen significantly from approximately 52% on October 4, to 33% on November 4.

Nonetheless, she remains the favorite to win the nomination. On the same day, former Vice President Biden traded at 22%, Mayor Buttigieg at 19%, and Senator Sanders at 14%. Interestingly, although she has not entered the race, Senator Clinton traded at 9%.

It appears that Warren’s collapse can be attributed to her unconvincing answers related how to pay for her Medicare-For- All plan. It seemed quite clear that her opponents viewed that issue as her weakest flank, and they attacked it aggressively during the last month.

The race for the Democratic nomination could be a long one. At the moment, it seems that the party is divided between the populist left platform represented by Warren and Sanders (with a collective 47% probability of either of them winning the nomination), and the moderate left represented by Biden-Buttigieg-Clinton (with a 50% probability).

Interestingly, in a recent New York Times/Siena College poll, Joe Biden leads or is even with President Trump in five out of six key swings states (Arizona, Florida, Michigan, North Carolina, Pennsylvania and Wisconsin).[x] Whereas Sanders and Warren, lead or are even with Trump in three of those six states.[xi] With the party so divided and Biden looking politically weakened by the attacks from his Democratic and Republican rivals in recent months, it is understandable that Hillary Clinton might see an opportunity to enter the race.

With the Iowa Caucuses scheduled for February 3, the next three months are a political eternity, where anything could happen in the race for the Democratic nomination.

Conclusion: I believe the major reversal in Fed policy, from effectively telegraphing a 3.00%-3.25% funds rate in late 2018 to now having a 1.50%-1.75% funds rate, contributed substantially to the 20+% appreciation in the S&P 500 this year. Despite the major uncertainties with US-China trade, Brexit and US politics, this year may be another example to support the axiom: “Don’t Fight the Fed”.

Using the same logic, the next year’s worth of equity returns will likely not be as easy. The Fed appears to be now on a more neutral footing. And if the Fed were to cut during the next year, it will likely be in response to new economic negatives. But, if policymakers can simply “do no harm”, then the global economy should begin to stabilize in the coming months; and certainly, more positive news with regard to trade, Brexit and US politics will help.

With the macroeconomic outlook appearing to be much better today, a “risk-on” investment approach makes sense. However, many significant questions and issues still exist, suggesting that we’re not out of the woods yet. The most market friendly scenario in coming months would appear to be a dovish Fed, political stability in the US, a clear path to Brexit (finally!), and more constructive dialogue and progress between the US and China. The bear market scenario could well include one or more of these variables going horribly wrong.

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).

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•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.

[i] “Trump Touts US-China Phase One Trade Deal, Delays Tariffs,” by Jennry Leonard, Saleha Mohsin and Shawn Donnan, October 11, 2019, Bloomberg.

[ii] “UK, EU Reach Brexit Deal – Now Comes the Hard Part,” October 17, 2019, The Associated Press.

[iii] Source: St. Louis Federal Reserve.

[iv] Source: Yahoo Finance.

[v] Source: St. Louis Federal Reserve.

[vi] “The Fed’s View on Inflation Is Quietly Shifting. Here’s Why,” by Jeanna Smialek, November 1, 2019, New York Times.

[vii] “US-China Trade Deal Signing Could Be Delayed Until December – US Sources,” by David Brunnstrom and Matt Spetalnick, November 6, 2019, Reuters.

[viii] “These Four Charts Show How the UK Election, and Brexit, Could Play Out,” by Holly Ellyatt, November 7, 2019, CNBC.

[ix] “Mitch McConnell: A Senate Impeachment Trial ‘Would Not Lead to a Removal,” by NBC News, Youtube.

[x] “Trump Is Competitive in Six 2020 Swing States Despite National Weakness, Polls Say,” by Jacob Pramuk, November 4, 2019, CNN.

[xi] Ibid.