The slow melt-up in US equities to fresh record highs in mid-July took many market participants by surprise, especially considering the rather ominous trade and geopolitical backdrop. Between the slowest quarterly GDP expansion in China in 27 years and speculation that the US could be heading towards the first earnings recession since 2016, the latest equity rally contrasts with the myriad risks facing the outlook.
Since the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite charged to fresh heights on July 15th, momentum across major benchmarks has been decidedly negative, declining despite the growing likelihood of fresh policy easing from the US Central Bank. Although optimism that the Federal Reserve would cut interest rates to fend off sluggishness in the economy helped propel stocks to fresh heights, sentiment has rapidly turned pessimistic as downside risks mount. Now the prevailing question is whether the stock market will rebound higher and reach new highs or sustain its most recent descent.
Are Cracks Forming In The Longest Bull Market On Record?
Stock benchmarks, especially the S&P 500, have long been lauded as leading indicators of economic activity. Because stocks are priced based on forward-looking expectations, stocks have a long and established track record for foreshadowing the economy’s trajectory. While sentiment has been strong, especially as unemployment remains near the lowest levels in decades and growth experiences tailwinds from tax changes and tariffs, sluggish inflation and softer earnings are possibly forming the conditions for a perfect storm in stocks.
In normal conditions, good economic news would generally translate to positive momentum across stocks, and vice versa. However, after more than a decade of historically low interest rates, there are other catalysts at play as investors continue to chase after risk in a low yield environment. Instead, negativity has counterintuitively emerged as a positive stimulus for stocks. Among the leading factors behind the rally during the first half of July was the ongoing stare-down between President Trump and the US Federal Reserve. While the Federal Reserve has historically been behind the curve when it comes to major policy decisions, shifting stances amongst key members increasingly reflects Trump’s demands for lower rates.
Fed Chairman Jerome Powell has raised concerns regarding the US economy—news which sent stocks soaring as investors anticipated policy easing. After aggressively raising rates the past few years, the Fed has paused its rate tightening efforts. Moreover, the increasingly dovish stance taken by several prominent members of the Federal Reserve underscores the growing likelihood of a rate cut as early as this month. This recent shift echoes recent developments Fed Funds futures tracked by the CME FedWatchTool, which now puts the likelihood of a 0.25% rate cut later this month at 74.5% (as of 07/25/2019).
Although the possibility of lower rates was initially viewed as positive for stocks, equity indices’ climb to fresh heights has been largely predicated on “TINA”, short for “There Is No Alternative”. TINA represents the idea that low rates prevailing across the globe make stocks more attractive. Historically, low rates tend to lead to higher rates of stock accumulation as bond yields slide, channeling yield starved investors towards riskier assets.
However, TINA may not be enough to buoy stocks as evidenced by Friday’s selloff, which quickly erased Thursday’s gains amid surging tensions in the Persian Gulf. Additionally, increased expectations that any rate cut would be more conservative than the 0.50% cut sought by market participants dampened sentiment. In response, the tech-centric Nasdaq Composite tumbled 0.74%, followed by the 0.62% contraction in the S&P 500. With earnings season now in full swing, any deterioration in the data or outlook could extend the weakness that has most recently enveloped stocks.
FAANGs The Canary In The Coalmine?
Although a wave of corporate earnings announcements are set for release throughout the week, early indications have not been all that positive, especially for the tech sector. Netflix managed to beat Wall Street’s estimates for both revenues and earnings during second quarter, but it was not enough to reassure investor concerns about the pace of subscriber growth. Netflix shares sank by more than 10.00% after the report before extending the loss by an additional 3.11% on Friday. With other FAANGs, which represent nearly 20% of the entire S&P 500 market capitalization, set to report results over the coming days and weeks, earnings figures could very well be the deciding factor for stocks forthcoming directional momentum.
However, this is not the only significant factor at play for stock indices, especially as President Trump’s jawboning is felt across asset classes. His most recent spat with the Federal Reserve over interest rates is just one example of his outsized influence over policy and market momentum. Another is his recent comments on the US dollar and increasing inclination towards weakening the US currency. Trump has already demonstrated his willingness to explore options for improving US competitiveness in global markets, and weaponizing the dollar is a possible initiative that could support these ambitions.
Weakening the dollar can deliver two major advantages at a point where trade negotiations are stalled, and the latest leg of the equity bull market is increasingly strained. For one, a weaker US dollar helps US exports maintain their global competitiveness. Second, a weaker US dollar by extension makes stocks cheaper on a relative basis when compared to other regions like Europe, incentivizing accumulation. Part of the recent pressure on the Federal Reserve to cut rates might serve the ambition of weakening the dollar, as lower interest rates typically correspond with a dip in the local currency.
Even though a near-term rate cut is not guaranteed, market participants are on the side of lower rates, which indicates the strong possibility of further downside for the US dollar, especially if Trump takes action to weaponize the dollar for trade. One strategy for mitigating the rhetoric and possible outbreak of a fresh currency war is to hedge against risk in foreign exchange markets by exploring short exposure to instruments like the US Dollar Index (DXY). Another option is exploring the potential of haven assets like gold which has recently surged to multi-year highs. However, as the last major stock market downturn demonstrated, a risk-off environment might stoke dollar demand as investors ditch risk for the perception of quality assets.
A Time for Caution
Many developments hang in the balance for US stock benchmarks as US earnings season gets into full swing. Chief among the concerns are the possibility of further earnings disappointments, slowing economic momentum, and expanding conflict on both the trade and political fronts. Without a trifecta of falling interest rates, a weaker dollar, and positive earnings results, record highs in stocks may quickly give way to sharp declines across benchmarks. Historically, downward corrections in valuations occur swifter than moves higher. With all the myriad downside risks in mind though, investors should tread cautiously heading into the upcoming earnings announcements before the Federal Reserve interest rate decision is delivered on July 31st.