Trouble Ahead, Trouble Behind

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Trouble Ahead, Trouble Behind

August continues to live up to its reputation as a tough month for US and global equity markets:

  • Friday’s 2.6% decline on the S&P 500/3.0% drop for the Russell 2000 puts month-to-date returns at -4.5%/-7.3%.
  • Still, at least US stock markets remain comfortably up YTD, +13.6%/+8.2% for the S&P and Russell respectively.

That performance is, at least, generally better than:

  • The MSCI EAFE Index, down 3.8% MTD and only 5.4% higher on the year in dollar terms.
  • The MSCI Emerging Markets Index, down 6.5% MTD and now down 0.3% YTD in dollar terms.

Since we’ve been recommending clients favor US large caps over any other option for equity exposure back to the start of DataTrek in 2017, these relative returns are in line with our worldview. And given the current global investment climate, we’re sticking with our basic narrative: the S&P 500 is the place to be.

Now, zooming in on just Friday’s capital markets price we did see 4 things that surprised us:

#1: Fed Funds Futures did not start discounting a 50 basis point cut in September.

  • Fed Chair Powell’s Friday morning speech at Jackson Hole was largely a historical review of monetary policy and light on current-day observations. His message on the latter point was the same as at the July 31st press conference: the Fed “will act as appropriate to sustain the expansion”.
  • President Trump’s tweets through the day may have caused equities to drop, but that did not carry through to market pricing for future Fed action.
  • At Friday’s close, Fed Funds Futures only put 5% odds on a 50 bp cut in September. That was actually lower than Thursday’s odds of 9%.
  • Also worth noting: assuming the Fed does cut by 25 bp in September, Futures indicate the odds of a 50 bp cut at the October FOMC meeting are only 3%.

Takeaway: Federal Reserve communications have conditioned the market to believe any “Fed Put” remains far below current US stock prices. That, in our view, was one underappreciated reason US stocks traded so poorly on Friday.

#2: The dollar weakened:

  • The DXY Index fell by 0.91% to 97.26, its lowest level in over a month.
  • We would have expected to see the dollar rally on a risk-off day, or at least tread water. The greenback has been resilient all year even in the face of trade war fears and a slowing US economy.
  • A weakening dollar should have also helped put a floor under US stocks, but instead they closed near the lows for the day. A weaker US currency, after all, helps corporate profitability since 38% of S&P 500 company revenues are from offshore.

We did see press accounts over the weekend that attributed the dollar’s slide to worries that the US will engage in currency market intervention. That seems purely speculative at this point but worth mentioning. George Soros… Call your office…

Takeaway: that stocks could not rally despite the dollar’s pullback is a worrisome sign about near term equity market direction.

#3: Neither 10-year Treasury nor 10-year German bund yields made a new low for the year:

  • Treasuries ended the day with a 1.533% yield versus the August 15th lows of 1.527%.
  • German bunds closed with a -0.678% yield on Friday versus an August 15th low of -0.701%
  • The S&P’s 2.6% decline on Friday may not have been as severe as the 2.9% drop on August 14th that pushed US/German yields to their 2019 lows the next day, but there’s little doubt that the US-China trade war continues to heat up. So why aren’t yields breaking to new lows in response?

Takeaway: Friday’s relative stability in global sovereign debt markets was unusual given the equity selloff, but given fresh economic uncertainty we don’t see it lasting. US 10-year TIPS spreads are down to 1.54 points, the lowest in almost 2 years, and 5-year break-evens are just 1.35 points. Both point to market pricing that is seriously below the Fed’s 2% inflation policy objective.

#4: The offshore Chinese yuan broke out to a new high:

  • Friday’s close was 7.18/$, 0.58% weaker than Thursday. The prior lows for the yuan were on August 12th at 7.10/$.
  • This is well above the official exchange rate of 7.096/$, indicating that markets believe Beijing will have to weaken the currency further to offset the effect of fresh tariffs on Chinese exporters.

Takeaway: the yuan exchange rate is getting further and further from its old line in the sand of 7/$ and this will likely serve to amplify tensions between the US and China this week.

What these 4 points tell us: We are not yet at an investable bottom for US stocks, and quickening cadence of bad trade war news makes spotting a low incrementally harder. As for where there might be a “Trump trade put”, akin to a “Fed Put”, consider that the S&P 500 is still +25% on a price basis from Inauguration Day 2017, when it closed at 2271. The Dow Jones Industrial Average, the President’s preferred measure of stock market performance, is still 29% higher than that day when it closed at 19,827. Don’t, in other words, expect another 5-10% pullback to change the Administration’s thinking about US-China trade.