2019: The Year of the Fed and China Variables

By Paul Hoffmeister, Chief Economist

During the first week of 2019, we explained that our base case stock market scenario this year was for a 15% return in the S&P 500. So far, the S&P 500 has rallied more than 23%, not including dividends.[i] To us, the key driver of equities this year has been strongly dovish Fed policy, which has seemingly confirmed the adage: “Don’t fight the Fed.”

Arguably, the most important distinguishing feature between December 2018 and December 2019 is the fact that a year ago, many FOMC members were telegraphing two to three rate increases during 2019, whereas the reality has been that the FOMC has actually reduced the funds rate this year by three quarter points. In other words, rather than the funds rate going up in 2019 from a 2.25-2.50% range to 3.00-3.25%, the funds rate has DECLINED to 1.50%-1.75%.

And indeed, on January 4th after weeks of market panic, Chairman Powell saying that the Fed would be “patient” in raising rates appeared to mark the critical inflection point for the policy outlook and stocks have seemingly never looked back.

As such, we’ve seen a major U-turn in Fed thinking this year from one focused on slowing growth because of inflation fears, to one focused on supporting growth in the face of myriad macroeconomic risks, including the slowing global economy and trade frictions.

Notwithstanding, this year’s stock market performance has been ostensibly unremarkable or even boring, with the S&P 500 gradually floating higher for most of 2019. The Fed-catalyzed stock market rally was, for the most part, meaningfully interrupted only twice with the small selloffs in May and August. Both of those episodes appeared to have been sparked by negative news related to the US-China trade conflict.

Interestingly, when one looks deeper into the market behavior of 2019, the negative US-China trade news in May and August appeared to have also caused the Treasury curve to invert; while the announcement of a “Phase One” trade deal on October 11 appeared to cause the curve to steepen. This impact of the US-China trade variable on the Treasury curve suggests that these trade negotiations are having an important impact on economic growth at the margin.

Unfortunately, the US-China trade conflict doesn’t seem like it will be completely resolved anytime soon. The supposed Phase One deal announced in October has yet to be consummated, even though it was scheduled to be finalized in November. Even more worrisome, Phase One arguably encompassed many of the easiest aspects of the disagreement to be resolved. If this was supposed to be the easy part, how long will Phases Two and Three take to complete?

The recent comments from President Trump signaling that a trade deal may not happen until after the 2020 elections supports a pessimistic outlook for this variable. The remark may well be a late stage negotiating tactic to complete the Phase One deal. Or it could be a sign that, in fact, Beijing and Washington are so far apart on a deal that we are a long ways from any meaningful resolution. I believe both are true: this is negotiation, and there is serious disagreement about major trade issues that will require years to be resolved comprehensively. The best case scenario for this variable in 2020 could be that a Phase One deal is reached, and both sides maintain a constructive dialogue throughout the year.

With the US and China in a protracted trade conflict, we should expect the uncertainty and the reorganizing of global supply chains to weigh on global economic activity during the near-term.

Why would companies invest billions in new capital investment if supply chains are at risk and economies appear to be slowing? Unfortunately, too, this may be an environment that continues to put the entrepreneurial segment of the global economy at a great disadvantage relative to the largest companies that have more capital and “business moats” to weather economic uncertainty. This is unfortunate because arguably entrepreneurs and small businesses are the lifeblood of a thriving, dynamic economy.

This cautious view of near-term economic conditions appears to be underscored by the fact that some credit spreads have not fully “healed” (i.e. narrowed) to where they were in late 2017, early 2018 – before the trade conflict erupted.

For example, according to the St. Louis Federal Reserve, the Baa-Aaa spread currently trades at approximately 91 basis points, compared to a relatively tight spread of 65 to 70 basis points in late 2017, early 2018. As I see it, a wide or widening spread reflects higher risk aversion and less economic growth; whereas a tight or tightening spread reflects less risk aversion and less growth.

Even though this spread has narrowed since early 2019 from more than 120 basis points, investors are not willing to pay up to the same degree that they did two years ago for assuming the additional investment risk. In our view, this makes sense: two years ago the economy was accelerating to a nearly 3% GDP rate (year-over-year), whereas today it simply does not have the same horsepower with GDP likely growing less than 2%.[ii]

Something is restraining the global economy. While volatile currencies and growth-inhibiting tax rates are a pervasive problem, the US-China trade conflict may be the most acute issue.

In summary, this year’s “risk on” rally in equities and the Fed’s U-turn on interest rates are much welcomed. And, a dovish Fed posture next year will be extremely important, and likely creating a nice tailwind for risk assets. But the outlooks for growth and risk are not as strong as the 2019 rally might suggest, and it may be due to US-China trade uncertainty. For as long as the trade conflict persists, it should act as a governor on animal spirits and risk-taking. Therefore, it’s likely that one of the most important catalysts for financial markets in 2020 -- beside Fed policy -- will be trade. It could determine whether we have another strong equity market performance or whether we have an eruption of panic about commerce between the world’s two largest economies and the resultant fallout from even slower growth. We’re marking December 15th on our calendars. This is the deadline that President Trump has set for another round of tariffs on Chinese imports, which could certainly happen if Phase One isn’t finally completed.

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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Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

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

[i] Source: Dow Jones.

[ii] Source: Bureau of Economic Analysis