The market is currently embraced in a tight two-way tug of war between a dovish Fed hell-bent upon cutting rates to "sustain the expansion" and a soggy start to Q219 earnings. The market is pricing in about three rate cuts in 2019 with the bond market in sync. The Fed has yet to deliver on its first rate cut of at least 25 bps until perhaps when they gather for the July FOMC meeting. The stock market is at all-time highs, earnings for the quarter are projected to be down 2%-3% year over year with a lot of focus on profit margins peaking, and trade war uncertainty is hampering business to grow and spend on capex. Whether this is an insurance cut or the Fed is concerned that they are yet behind the curve is unclear.
There is no doubt the U.S. economy is slowing down, whether it warrants a cut at this stage of the cycle is perhaps debatable. Especially when one can argue that the stimulus-driven world of the past decade has led to nothing other than asset price inflation and wealth inequality. Global debt has now spiraled to roughly $200 trillion worth ~ 225% of GDP. Despite that, central banks around the world know no other way than to keep pumping money to inflate the cycle even further.
In Germany, investors are willing to accept a negative 0.27% interest rate per year via the 10-year Bunds. They are paying the government to take their money! The latest fad (absurdity even) is witnessed in select European Junk Bonds that are now trading on negative yields as well. A junk bond by definition is a company that has a high chance of default or may not even be around by the time the bond matures, yet investors are parking their money in more and more risky instruments to soak up even a tiny amount of yield. Doesn't this sound strikingly similar to 2007 and the mortgage backed securities crisis?
Freight volumes are a good indicator of the health of the economy. Volumes in the U.S. were up by just 0.8% in the three months from March to May vs. the same period a year earlier. Freight is growing at the slowest pace since the mid-cycle slowdown in 2015/2016. Ports such as Hong Kong and London, the busiest air cargo hubs in the world, reported that volumes fell by 8% and 6%, respectively, vs. 2018, with some ports turning negative in May and June. U.S. ISM new orders typically lead retail sales by one quarter and the latest read hit a low of 50, suggesting that retail sales could slow further. Manufacturing indices point to a further slowdown ahead. Measures such as employment are lagging, so to hang one's hat on that alone could be misleading. The big question is whether Fed Chair Jerome Powell will try and jump the gun and cut rates by 50 bps, which might spook the market, As the saying goes, "When the Fed panics, the market panics more!"
Looking at earnings, what can or should drive the market higher or lower? We have seen U.S. banks like JP Morgan (JPM) , Citigroup (C) , and Wells Fargo (WFC) report recently, some beating on revenues but some weak on trading and outlook. One trend is apparent: net interest margin is shrinking. As the Fed and central banks are bent upon leaving rates lower for longer, causing a flatter yield curve, this kills the profit margins for banks. Deutsche Bank (DB) is the latest victim of this yield curve dynamic. If Fed cuts rates too low, these U.S. banks will get crushed, especially the likes of Wells Fargo that rely on mortgage origination. It will be interesting to see how the big tech companies report towards the end of July, to see how corporate margins are effected by the trade war and the higher cost of imported goods and labor costs. For now, the U.S. earnings season is giving no hints of earnings upgrades going forward and fails to boost a market already running out of steam as it tries to hold above 3000 level in the S&P 500.
One needs to keep an eye on the U.S. bond market. The slightly better than expected June data caused a selloff in bonds, causing 10 year yields to trade above 2% again. This can have a significant domino effect if yields continue trading upward, either via better economic data suggesting the Fed may not need to cut as much as market expects, or higher yields causing the offloading of debt. When yields rise, the discount factor for equities moves higher causing lower valuations, and bearish risk assets. The worst combination can be slower growth and higher yields as inflation starts rearing its ugly head. And in a world of stagflation where the Fed will have their hands tied to cut rates lest it lets inflation get out of control.