The Federal Reserve’s (Fed) recent 50 basis point rate cut has significantly impacted the stock market. Undoubtedly, the size of the reduction in rates surprised most investors, expecting only a 25 basis points cut. The following is our expectation of the U.S. economy going back to Phase II or III in the economic cycle and some essential vital factors driving financial markets after the Fed’s bold move:
- Economic Support: Rate cuts are indeed seen as a proactive measure to support the economy amid softening economic data. According to Standard & Poor’s, GDP growth is expected to slow to 1.8% next year from 2.7% this year. Therefore, consumers are expected to rein in spending in the upcoming months. The Fed’s gradual cutting of interest rates may be seen as a preventive measure to protect growth from slowing too much and the economy entering a recession. Investors have generally welcomed this type of move, leading to initial positive reactions in the stock market.
- Sector Performance: Different sectors are reacting in varied ways:
- Large-cap stocks, especially mega-cap stocks, benefit most due to their strong balance sheets and ability to access cheaper capital.
- Small-cap stocks may see a delayed response but could gain momentum once economic conditions stabilize.
- Treasury Bonds: Bonds perform well as their prices always rise when interest rates fall. Currently, the spread between treasuries and corporate bonds, including high yield, is narrowing, and there are no signs of stress in the fixed-income market. This is positive for the stock market. Nevertheless, the yield curve has been inverted for two years. For many, the inversion of the yield curve occurs in anticipation of an economic recession. However, there is another reason for the yield curve to remain inverted without getting into a recession: inflation. I want to make two critical observations when the yield curve returns to normal in anticipation of more favorable monetary policy and interest rate cuts:
- Historically, if this type of move occurs when the economy slows down too much, the risk of recessions looms, and the stock market adjusts lower after the yield curve returns to a normal shape.
- However, history shows that if inflation was the cause of the inversion, the normalization of the yield curve may not be the prelude to a stock market correction or, even worse, a bear market. Is it contradictory to the previous scenario? Yes, therefore, indecision and volatility prevail in the current environment.
- Although stock investors are expecting more rate cuts since the Fed’s intervention, bond yields are moving higher, not lower. If bond investors believe the Fed will be able to continue cutting rates, bond yields should be moving lower, not higher. The immediate consequence of higher yields (lower bond prices) is a test of support by the U.S. Dollar, which now seems to be regaining upward momentum due to higher yields. Perhaps the strong labor report we saw on Friday and higher yields suggest we won’t have more rate cuts soon.
- Real Estate Investment Trusts (REITs) benefit from lower borrowing costs for real estate acquisitions and development. Unlike lower-paying corporate bonds, the dividends paid by REITs make them attractive to investors, who use them as a proxy for bonds.
- Gold: Gold performs well during rate-cutting cycles, especially if the economy slips into a recession and the dollar weakens. The lower the interest rates, the better for gold. If the uptrend in yields continues and the U.S. Dollar regains upward momentum, gold should stall or underperform.
- Lower interest rates have negative consequences for the US Dollar and positive implications for commodities. The current short-term trend @GCCM of the US Dollar is changing from bearish to bullish. The currency is regaining upward momentum, and some commodities, mainly copper, are regaining their uptrends. Therefore, we expect an uptick in inflation during Q4.
- Market Sentiment: Investor sentiment is mixed. Cyclicals usually outperform defensive sectors in a low-rate environment. However, the overall market reaction has been choppy, reflecting uncertainty about the economic outlook. Some economists expect a soft landing of the economy, the Fed’s desired outcome; others expect a hard landing, and the economic future is bright for others.
- Risks: Several risks could impact market performance in the coming months:
- Presidential Election: The upcoming election could lead to market volatility, especially if there are significant changes in economic policies. U.S. presidential elections have been known for two dominant political parties, center-right and center-left, on social issues but with similar economic interests. Not this time. The economic policies of each party are way apart from each other and may deliver very different results.
- Economic Recession: The markets may respond negatively if economic data shows significant deterioration.
- Geopolitical Tensions: Trade tensions, energy supply concerns, and global conflicts could exacerbate market volatility. We saw it on October 1st.
Overall, while the rate cut has provided short-term support to the stock market, investors remain cautious about the potential risks ahead.
Conclusion: We are constantly monitoring the rotation of capital and many other variables affecting financial markets to determine probable market direction. Are they all pointing to a sustainable short-term bull market in the U.S.? No. Nonetheless, we remain bullish for Q4.
Large-Cap value continues outperforming growth stocks. However, from time to time, profit-taking and short-term relative weakness in value stocks occur. In that case, there is only one way the S&P 500 Index can hold its current level or move up: renewed strength in growth stocks such as technology and consumer discretionary. If it doesn’t happen, expect another short-term period of increased volatility and weakening stock prices. However, technology and consumer discretionary strength should prevent a significant selloff even if there is profit taking in value stocks. The charts below show the S&P 500 Index above its July and August picks and the Nasdaq 100 Index trading slightly above its August pick and below July.
In the short term, we remain cautious due to our expectation of inflation re-accelerating slightly in Q4, but we remain bullish in the long term. Even if inflation reaccelerates in Q4, both GDP growth and the labor market indicate that the U.S. economy is not entering a recessionary period. We may return to Phase II or III in the economic cycle. During the latter, inflation accelerates, and GDP decelerates. During the former, both accelerate. History shows that the stock market did not collapse during Phases II and III. The blue dotted vertical line on the chart below indicates September 18th, when the Fed lowered its Fed Fund rate by 50 basis points. By the behavior of the two-year treasury yield returning to 4.00% (red shaded box showing a 10.7% increase), I would assume bond investors are signaling a re-acceleration of inflation in Q4, which is not what the Fed wants.
The S&P 500 Index chart below shows the first level of support in the 5600 area marked with a red-shaded long horizontal box. At the time of this writing, the index is at 5739. The first indicator below the chart shows bullish momentum for the index, indicated with a green-shaded box. The second indicator below the chart shows value under-performing growth (technology) in a red-shaded circle. Thus, the stock market remains up while the outperformance holds. And the bottom indicator highlighted in red shows that volatility remains high (two red circles).
Currently, subject to change as new data becomes available, our worst-case scenario shows S&P 500 support in the 5100 to 5200 range, indicated as “Main Support” in a red-shaded box. It would be a -9.00% to -11.00% correction. Is it possible that the S&P 500 drops to the 5100/5200 area during October? Sure, anything is possible in a problematic world such as ours. But is it probable? No, not in our opinion, as long as inflation does not become out of control and geopolitical conflicts do not escalate, becoming more of a worldwide conflict or black swan event.
With best wishes,