As the fourth quarter began, the S&P 500 index sat just below an all-time high, with expectations that earnings would continue to surprise to the upside and Q4 GDP would again post 3% or greater growth. But those expectations were almost immediately dashed by a trifecta of confusing news in the form of Chairman Powell backtracking on his hawkish comments from a month earlier, plunging oil prices, and the trade war with China.
In the first paragraph of last month’s market update we describe Chairman Powell’s October 3rd speech as the most hawkish in a decade. So hawkish that we wrote “one wonders if the Fed is prepared to raise the Fed Funds above the 3.0 to 3.5% neutral range.” On the back of that comment and the stock market plunge that followed, President Trump took to criticizing the Fed Chairman for jeopardizing the sustainability of the economy. Apparently, Powell took the criticism to heart because just a month later, at his presentation to the Economic Club of New York, he softened his tone materially. In the speech he described the current Funds rate as being just below the lower end of the range of estimates for the neutral rate. With the overnight rate currently targeted at 2.0% to 2.25%, Powell’s comment suggest that investor perception of the neutral rate is too high and the “risk-off trade” (stock prices lower) reversed. That was the initial reaction to the comment and the stock price rally continued into the next week as investors were cheered by comments that the U.S. China trade spat was showing signs of easing.
However, that wasn’t the only issue concerning the markets. The second “spur in the side” of investors was falling oil prices. Historically a fall in the price of oil was deemed a net benefit to economy as it was the equivalent of a tax cut for consumers. However, the U.S. has become a large producer of the commodity; so much so that last month the country exported more oil than it imported for the first time ever. With the price of the oil falling, the profitability of domestic producers falls as does the credit quality of those companies. Over the two-month period ending December, West Texas Intermediate prices have fallen about 30%, prompting worries that banks exposed to the sector could experience a wave of defaults. With that worry came broad based weakness in stock prices.
The third source of investor anxiety has been the ongoing trade war with China. The sabre rattling which had intensified for the first two months of the quarter seemed to subside somewhat following the G-20 meeting in early December. A meeting between Trump and China President Xi yielded a delay in further sanctions for 90 days with the hope that the entire matter could be resolved in that time. However, the arrest of Huawei CFO Meng Wanzhou, the daughter of the founder of Huawei Telecom, has complicated matters. The charge is that she circumvented trade sanctions with Iran and is being held without bail, being deemed a flight risk. The Chinese government has been vocal in their displeasure with the arrest and the company has denied wrongdoing. At the time of this writing, she remains in custody and the impact that will have on trade negotiations is not clear.
What is clear is that investors don’t like the degree of uncertainty that’s arisen in the capital markets. The economy continues to generate jobs at a robust pace as the number of unfilled jobs remains at an elevated level. Moreover, with inflation continuing to tick higher, we believe that Chairman Powell’s comments in October were a true description of monetary policy. But given the heightened market volatility and his walking back of those comments at the economic club luncheon, we expect that the Fed will raise the overnight rate by 25 basis points in December, as expected, but will sound a dovish tone at the post-meeting press conference. Moreover, we now think that rate hikes in 2019 will be limited to two.
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