As the financial world waits to see what the Fed has planned for interest rate cuts—the first since 2008—debate grows over odds for a recession or if an "insurance cut" will prevent a further slowdown in economic activity. Financial Sense Newshour spoke with Ari Wald of Oppenheimer & Co., and Ryan Sweet at Moody's Analytics, on why they think the bull market and US economy still have room to go.
Historical Rate Cut Modeling
The Fed funds futures market is pricing in a rate cut, but the size of the cut may have important implications for the economy. In studying the last nine rate cutting cycles going back to 1971, Wald found when the Fed cuts by 25 basis points or less, there are typically higher forward returns in the market.
Some call a 25 basis point cut an insurance cut. This indicates the Fed is attempting to get ahead of the situation, Wald stated, and typically the market embraces the cut and continues heading higher. However, when the Fed cuts by 50 basis points or more, there is a greater likelihood of poor performance in markets and an elevated risk of a recession in the economy.
“Historically, when the Fed acts aggressively, when it has to cut by at least 50 basis points, it's usually too late,” Wald said. “The Fed funds futures market is currently pricing in an 82% probability of a 25-point cut, versus only 17.5 % of a 50 basis-point cut. The market is expecting this insurance cut and I think we should continue to see this march higher for equity prices.”
Sector rotations have been driven by interest rates and as the 10-year U.S. Treasury yield moved from three percent at its peak last year to recently two percent, we've seen a defensive-lead rally from sectors with countercyclical attributes.
Utilities, real estate investment trusts (REITs), consumer staples and higher dividend-paying sectors that tend to act as bond proxies are ahead. Wald noted that the safety trade is crowded and extended at this point. There is potential as interest rates mount a small oversold move to the upside to see cyclical areas of the market begin to participate.
“This is the key point of why we're bullish,” Wald said. “I think rates are finding a floor at two percent. I think they're due to start moving higher and I think this is the dry powder for cyclical. Already, we've seen some better action within financials and industrials. We're very encouraged by that. We think this those are going to be the areas that are going to help lead this next leg of the bull market.”
Inverted Yield Curve Signaling Problems?
It’s true that an inverted yield curve traditionally precedes a market decline, Wald said, but as a timing indicator, it’s a poor signal. “Either the inversion leads the peak in the S&P by over a year, or the inversion lags the peak in the New York Stock Exchange’s advance-decline line by over a year,” Wald said. “This means that weakness has already been well documented.”
However, the advance-decline line is making a new high, so in terms of market breadth, there’s currently no sign of trouble. The former scenario, Wald added, where the inversion signals future trouble, is more likely at this point. This means the peak in the S&P could be over a year away, and the setup could be for a recession sometime in 2020, though nothing is certain at this point.
“It does signal later cycle economic conditions,” Wald said. “Cyclical growth stocks should continue to outperform in that environment. The premium gets placed on those higher-growth companies in this low-growth world that the inversion is signaling.”
Consumers Holding Strong
With the Fed’s anticipated rate cuts stoking fears of recession, Sweet said we need to look at economic conditions to get a handle on what the risks actually are.
The recent escalation in trade tensions continues to scare markets and weighs heavily on manufacturer sentiment. Manufacturing is in a slump and, Sweet posited, may already be in recession. Business investment is another weak spot.
That state of the consumer is most important when it comes to the U.S. economy, Sweet explained.
“The consumer's got plenty of tailwinds,” he said. “The labor market’s tight, wage growth is picking up and inflation is low. Interest rates are low, the stock market's appreciating, and house prices are rising. As long as the consumer hangs in there, as long as the job market hangs in there, I think the risks of a recession are pretty low in the immediate future.”
Corporate Tax Cut Fizzling
Business investment didn’t receive a lasting boost from the tax cuts in 2018, though it isn’t surprising. Businesses thrive on certainty, and trade tensions are weighing heavily on their confidence Sweet said. Against that backdrop, it makes sense that business investment is slowing. The relationship between the corporate tax rate and capital spending—if there is one—is not strong. Tax cuts last year only served as a shot in the arm to the economy, Sweet stated, but it was only temporary.
“The tax legislation didn't alter the economy’s potential growth rate,” Sweet said. “That's typically a function of productivity growth and labor force growth. We're now just settling back into a more sustainable pace of growth. … A slowing economy isn't a recession. We weren't going to be able to duplicate the three percent GDP growth that we got last year into 2020. We're just settling down into what we got pre-fiscal stimulus for most of this expansion.”
