- Beginning in January and now continuing into February, stock markets have rallied on positive news in areas of concern – mostly on the policy front.
- We remain cautious as in our view, policy risk tends to be the most difficult to price, but also the most likely to surprise.
There are a lot of reasons to still be cautious in the New Year though the equity market doesn’t seem to agree. For January, the S&P 500 was up 8 percent and, as of now, that momentum is carrying through to February. However, let’s not forget 2018 also had a strong start with January up 5.7 percent. Oddly, this rebound occurred despite most of the issues that concerned investors at the end of 2018 still being in play. One reason may be that the “tone” on most fronts has changed. The Fed is signaling a more patient approach, the U.S and China are more actively negotiating and, while there is plenty of grandstanding, the government shutdown has at least temporarily ended. So, while we are waiting for final resolutions – there is hope that progress is being made on all three fronts.
The FOMC appears to have had a large reversal from the hawkish posture of 2018. The committee left the target for the fed funds rate unchanged with a 2.5 percent upper bound, but the language of its statement was more dovish than expected. Economic activity is now judged to be rising at a “solid” rather than “strong” rate. It also acknowledged that market-based measures of inflation compensation had moved lower. Perhaps most importantly, the FOMC discarded its promise of “further gradual increases” in interest rates and said it would be “patient” before making any further moves. The current “dot plot” of Fed Funds rate projections has given investors more confidence that interest rates are closer to neutral and further rate hikes will be limited.
Fed Funds Rate Projections
The FOMC is also “prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments”, although it will continue to unwind its balance sheet at the pace of up to $30 billion a month for U.S. Treasuries and $20 billion a month for mortgage backed securities as they mature. It was a bit surprising that balance sheet reduction was thrown into doubt, leaving some to question if the FOMC is worried about volatility being induced by the process. If so, we now we have the FOMC targeting (unofficially) . . . employment, inflation, asset prices AND volatility. The fact that the FOMC’s reversal is happening at 2.5 percent interest rates in the United States and negative interest rates in Europe and Japan highlights just how marginal growth has become.
The timeline below illustrates the circuitous path the tariff battles have taken in the last year. However, investors are hopeful that a potential trade deal with China and the United States is in the making. The countries have been in what appears to be constant, in-depth, discussions on economic and trade issues since the start of 2019. U.S. President Donald Trump has been optimistic, stating that the United States is doing well in trade talks with China. He has vowed to increase tariffs to 25 percent from 10 percent on $200 billion worth of Chinese imports on March 2nd unless China takes steps to protect U.S. intellectual property, end policies that force American companies to turn over technology to a Chinese partner, allow more market access for U.S. businesses and reduce other non-tariff barriers to American products. News outlets have been reporting a potential meeting for President Trump and President Xi Jinping on the horizon which could portend a breakthrough in the trade war that has consumed two countries that account for nearly 40 percent of the global economy.
Timeline of US and China Trade War Actions | 2018
Finally, on January 25th, President Donald Trump agreed to re-open the federal government for approximately three weeks without any guarantee Congress would provide money for his proposed border wall, his top campaign promise. The deal was negotiated by lawmakers after the 35-day shutdown, the longest in modern U.S. history, began to seriously impact air travel. Earlier in the day, LaGuardia Airport in New York was briefly closed due to a shortage of air traffic controllers, creating flight delays across the country. Under terms of the agreement, Trump signed a short-term spending bill (through February 15th) and Congress will immediately begin negotiating border security legislation.
It seems investors have seized on these seemingly positive developments to push equity markets higher but, as we discussed in our 2019 Outlook, in our view policy risk tends to be the most difficult to price, but also the most likely to surprise.