Weekly Market Update (June 17, 2019 – June 21, 2019)

Canadian and U.S. stocks finished higher for the third straight week, with the S&P 500 and the Dow closing at fresh record highs. The main catalyst for the rally in both bonds and stocks was the Federal Reserve (Fed) signaling its openness to rate cuts this year. The committee removed a previous statement about being patient in setting rates, which implied holding rates steady for some time, and added that it will act as appropriate to sustain the economic expansion. Other central banks are also shifting toward easier monetary policy, which has resulted in lower bond yields globally and increased risk appetite. Following the financial crisis in 2008, the U.S. stock market first achieved a new record high in early 2013. Since then, it has set 225 all-time highs (an impressive 14% of all trading days), indicating that new highs aren't a sign of exhaustion. We continue to believe that still-positive fundamentals, in combination with a favourable interest rate environment, provide a positive backdrop for stocks. But we expect more volatility along the way as this expansion matures.

The economic expansion is nearing the end of its 10th year. How can it be both well enough to keep growing and yet so vulnerable to risks that it could require a monetary intervention to continue? That was the question facing the Fed when it met this week to set the level of short-term interest rates. Though it kept rates unchanged for now, the Fed signaled that it would cut rates this year in response to slower growth prospects.

Markets reacted favourably to the Fed’s shift towards a rate cut, as U.S. stock prices rallied to a record high. Historically, the biggest risk to the bull market has been that the Fed makes a policy mistake. Markets get concerned when the Fed is deemed to be flat-footed and behind the curve as market and financial conditions weaken. By opening the door to a rate cut this year, the Fed provided assurance to markets that it was willing to prolong the expansion. Below we summarize what the Fed saw in its outlook, how the markets responded, and what they both mean for long-term investors.

The Fed: Inflation is softening, and wage growth is slowing.
In the latter innings of the economic cycle, inflation is more likely to diverge from healthy levels. Too much inflation indicates that the economy is overheating, and rising wages could induce firms to cut costs by slowing hiring, triggering higher unemployment. Too little inflation signals that demand for goods and services is decreasing and could lead to sluggish wage growth, reduced lending and weaker economic activity. The Fed believes that its 2% inflation target is consistent with healthy economic growth. Yet recent data shows that price levels are heading below that target, leading the Fed to drop its forecast for inflation from 1.8% to 1.5%.  If inflation continues to tilt lower, the Fed signaled it would cut short-term interest rates in an effort to boost demand and reset price levels closer to target. 

• Market reaction: U.S. 10-year Treasury yields dropped to 2.0%, the lowest levels since 2017 this week, before rebounding to 2.06%.¹ Though low, U.S. rates are still higher than most developed countries. For that reason, foreign demand for U.S. Treasuries will likely keep long-term rates low and help prolong the bull market by providing inexpensive credit to businesses and consumers.

• What it means for you: Since the gap between short- and long-term rates is small, we suggest investors include a range of short-term and intermediate bonds in their portfolios. Bonds of lower maturity aim to shield portfolios from market volatility in the late stages of the economic cycle, meanwhile reducing portfolio exposure to the risk of rising interest rates over time.   

The Fed: The economy is healthy, but its pace is slower.
The economy grew at a robust 3.1% in the first quarter, but showed signs of weakness as consumer spending slumped to half its average rate. A lackluster jobs report and slowing wage gains also added to slowdown fears.  

More recently, a slew of good economic data has alleviated the Fed’s concern of weakness in the consumer sector. First, a bounce back in retail sales data suggested a pickup in consumer spending. Additionally, benefit claims by unemployed workers, a leading indicator of recession, have fallen recently to well below the 10-year average for the economic expansion. Finally, interest-rate-sensitive sectors of the economy have strengthened from earlier this year. For example, May existing home sales increased for the first time in two months as lower mortgage rates boosted homebuyer demand.

The economy doesn’t get a clean bill of health from the Fed, though. Business investment has slumped as the effects of last year’s tax cut fades and uncertainty mounts around trade tensions. However, the Fed sees the economy growing at 2.1% this year, in line with the average pace for the expansion.

• Market response:  The S&P 500 rallies to a record high this week, reflecting market optimism that still-positive economic and earnings growth, in combination with accommodative monetary policy, should prolong the bull market.

• What it means for you: Economic fundamentals are slowing but appear solid enough for the bull market to continue and to support rising share prices this year. Consider adding quality diversification through small-cap stocks that, in our view, will benefit from lower interest rates and that are trading at attractive valuations compared with large-cap stocks.

The Fed: Higher tariffs and slower global growth are headwinds to economic expansion.

The Fed highlighted two uncertainties to its otherwise optimistic view of the economy: elevated trade tensions and slower global growth. These two cross-currents are interrelated, as trade drives almost 60% of worldwide GDP growth². Data out Friday showed that the trade-sensitive manufacturing sectors in the eurozone and Japan continue to contract. Also, a gauge of U.S. manufacturing dipped to the lowest levels since 2009. So a lot is riding on the resumption of trade talks between the U.S. and China at the G20 meeting next week. Though we think that a quick deal is unlikely, progress towards an agreement would likely be a positive development for the markets and the prospects for continued global expansion. Additionally, more stimulative monetary policy from the central banks in other countries should help stabilize global growth over time. Recently, both the European Central Bank (ECB) and the Bank of Japan have signaled their intent to ease already accommodative monetary policy to boost growth.

• Market Reaction: The markets have been sensitive to news of trade progress, leading to periodic bouts of volatility. We expect normal levels of volatility to continue in these latter stages of the cycle as markets continue to adjust to rising trade and global growth uncertainties.

• What it means for you: While concerns about rising tariffs and slowing global growth have increased, we expect international equity returns to be higher than U.S. equity returns over time due to above-average foreign dividend yields and attractive prices relative to large U.S. companies.

The Upshot: The Fed signaled possible rate cuts this year, but markets expect more.
Though it has tilted in the direction of a rate cut, the Fed is watching incoming data from the labour market as well as geopolitical news for signs of weakening economic conditions before making a move. Meanwhile, market participants have already priced in three rate cuts this year. The upshot is that by year-end the market expects benchmark rates to fall much more sharply than the Fed does. The disconnect between the Fed’s intention and the markets expectation will likely lead to periodic bouts of volatility, in our view. 

• What it means for you: Periodic dips in the market provide a good opportunity for long-term investors to enhance diversity in their portfolios by filling in gaps with high-quality assets at lower prices.

Looking ahead:  An ounce of prevention is worth a pound of cure. 
This week the Fed demonstrated to the markets its willingness to cut rates in order to head off rising risks from deflation, trade threats and a slowing global economy.  Long-term investors can also take steps to help cushion the impact of uncertainty and rising risks on their portfolios. We believe by staying diversified and including an appropriate mix of equities and bonds for your comfort with risk, investors can continue to make progress towards their long-term financial goals as the bull market endures.

^{Sources: 1. Bloomberg, 2. World Bank}

Nela Richardson, PhD
Investment Strategist

^{Bloomberg, 06/21/19. *5-day performance ending Friday. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results.}

The main economic report next week in Canada is April GDP, which is released on Friday. Also, the much anticipated G20 Leader's Summit is taking place in Japan on June 28-29 where President Trump and Chinese leader Xi are scheduled to meet in an effort to resolve the stalemate in trade negotiations between the two countries.