INSIGHTS

On December 03, 2018

AAM Viewpoints – Chairman Powell Attempts to Walk the Interest Rate Tightrope

There are always concerns (“wall of worry”) weighing on the capital markets that participants must consider, and currently we believe the dominant three are:

1. Have corporate earnings peaked?


2. Will the trade war escalate?


3. Will the FOMC (Federal Open Market Committee) overshoot?

Any of these singularly could cause a bear market or recession to ensue and presently concerns over the combination has the U.S. equity markets entrenched in its fourth worst selloff of this current bull market (the chart below depicts the five worst selloffs).

Source: AAM | Bloomberg data | Past performance is not indicative of future results.

Starting at the top of the list with peak earnings it is essential that we emphasize this topic has been on investors’ minds for the better part of the year and much to the dismay of many market prognosticators, year-over-year earnings growth for the S&P 500 (on a market-cap weighted basis) have actually increased in each of the first three quarters of the year. Their current level is 26.06% which is their highest point in almost eight years. Looking at median year-over-year earnings growth for the S&P 500 we show the last three quarters are 21.00%, 21.56% and 21.07% respectively. We prefer a median discussion as opposed to a market-cap weighted one as we believe it is more telling on how the average stock is faring. Given this data, it is probably more appropriate to talk about earnings plateauing than peaking. Clearly this type of earnings growth cannot be sustained in perpetuity, but we think the reversion toward the long-term average of approximately 8% will be orderly and robust enough over the next couple of years that it shouldn’t derail the equity bull market on its own.

The trade rhetoric is clearly taking a toll, but so far it seems to be more psychological than physical damage (perception versus reality). However, we are starting to see some physical cracks, and it should be noted that an extended or escalated skirmish could easily push the global economy into a premature recession. We should get more clarity on trade as the G20 Summit begins to unfold over the next couple of days in Argentina, but we are somewhat optimistic that the United States and China (the world’s two biggest economies) will begin to hammer out a deal. Unfortunately, this will most likely be a process that takes some time to work out and probably won’t be resolved during one dinner meeting in Buenos Aires. Given this we would expect multiple fits and starts, but we do believe it will get done just like it did with Mexico and Canada as it would behoove all involved to get this accomplished sooner rather than later.

In the past, the Chairs of the Federal Reserve have lived their professional lives in a fish bowl, but with the current administration it appears Chairman Powell has moved into the reticle. This makes a very challenging job even more difficult, akin to walking a tightrope high above a chasm as he tries to navigate all the intricacies of the last decades’ monetary policy and negotiate a soft landing. The good news is that this past week may have provided a slight glimpse behind the scenes. Going forward this may help alleviate the pressure and criticism leveled on Powell. For many, us included, it appeared the FOMC was running a bit on autopilot with three to four rate hikes per year on tap until a neutral rate was achieved. However, after Powell’s comments at the Economic Club of New York on November 28, it appears that the FOMC will attempt to be more data dependent going forward and that neutral might be lower than once feared. These comments helped propel the S&P 500 to a gain of 2.12% on the day and should help establish the double-bottom level of 2630-2640 for the S&P 500 as a solid near-term nadir.

Positive news on these three concerns could be the catalyst to allow the equity markets to move back toward record territory as we close out 2018 and move into 2019. Unfortunately, we won’t get a real look at 4^th quarter earnings until late January 2019, thus it will most likely be developments on trade and interest rates that will be the near-term drivers. As stated above, we are confident that positive developments on both are forthcoming, though the road will most likely be bumpy. In the meantime, we encourage investors to stay patient as we attempt to navigate what we believe is just another selloff in a continuing equity bull market.

CRN: 2018-1203-7071R