07/30/2019
Equity investors welcomed the advance estimate of second quarter U.S. GDP that showed the expansion remained on track but was not likely strong enough to dissuade the Federal Reserve from cutting interest rates this week. The 2.1 percent annualized growth rate was well down from the unrevised 3.1 percent pace of the first quarter, but nevertheless exceeded the consensus forecast of 1.8 percent. The components of the report reflected the larger forces currently affecting the economy.

A particular source of strength was consumer spending, no surprise with both unemployment and inflation as low as they are. Government spending was also strong, again no surprise with scant attention being paid to deficits, as evidenced once again by the budget deal reached between the administration and Congress and passed by the House last week. On the other hand, business spending was weak, consistent with the uncertainty created by the ongoing trade disputes. Exports fell for the same reason.

Equity Investors Embraced Last Week’s GDP Report

Following the release of the GDP report on Friday, expectations for a Fed rate cut this week shifted fractionally away from a half point cut in favor of a quarter point cut, but the overall combined odds of one or the other remained at 100 percent. For equity investors, this was the best of both worlds, decent growth and an expected rate cut. The S&P 500 closed the week at a record high at 3026.

Since Fed Chairman Powell in early June voiced his willingness to support the expansion, the index has climbed 10 percent. And, not surprisingly, it has been the cyclical groups that have led the way higher, with the biggest gains coming in technology, communication services, consumer discretionary and financials. In that same interim, the trailing P/E ratio of the index has climbed from 18X to 19.8X. That move was reinforced by BBB credit spreads, which have narrowed steadily since early June to a new low for the year last Friday.

Stocks Could be Primed for Disappointment

This degree of multiple expansion could be setting up stocks for disappointment, however. With earnings growth in the second quarter expected to be roughly flat, following a similar experience in the first quarter, it is clear that this last leg of the rally is primarily attributable to expectations for multiple Fed rate cuts. Futures markets currently ascribe almost 80 percent odds of at least two quarter point cuts by year-end, and 50 percent odds of at least three. With stocks now at record highs and earnings growth flat, and the trade war with China looking like it may persist for longer than hoped, that puts a lot of burden on the Fed to be sufficiently dovish this week to justify the market’s expectations. If the Fed disappoints, some of the air could come out of the multiple expansion balloon fairly quickly.

Just how robust the economy was at the start of the third quarter will come into focus this week with the July reports on employment and manufacturing. Both are expected to be relatively strong, perhaps adding to the uncertainty of just how aggressive the Fed will be. After this week the Federal Open Markets Committee (FOMC) does not meet until the third week of September, so it will have ample opportunity to judge for itself. It is also a big week for economic data from the Eurozone, including second quarter GDP, consumer prices, retail sales and business and consumer confidence. And from China we will get the latest reading on manufacturing activity. U.S. and Chinese trade negotiations are set to resume this week in Shanghai. And although expectations are low, any constructive progress might be just the fillip stocks need to push still higher, even if the Fed does disappoint.

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