In 2008, the Federal Reserve lowered the Federal Funds rate to zero in an effort to stabilize financial markets and stimulate economic growth resulting from the Financial Crisis. This was an extraordinary measure to deal with extraordinary times. Over the subsequent years the financial system, markets and the economy slowly recovered.
Then began the debate, when should the Federal Reserve begin to raise rates to more normal level and how quickly should this be done. Starting in December of 2015 the Fed raised the Fed Funds rate by just 0.25% and raised it again by this amount the following December. In 2017, the Fed increased the Fed Funds rates three times, 0.25% each time. The Fed raised rates four more times in 2018 bringing the rate up to a more normal 2.25%.
The Fed walks a fine line in trying to get rates to the level that keeps inflation under control and keep the economy/employment healthy. It was feared that the Fed went too far with last year’s increases and global stock markets sold off hard at the end of 2018.
As plastered everywhere in the media, the yield curve did invert earlier this year which is often a signal that a recession is on the horizon. The rise in interest rates in the United States did indeed cause the dollar to rise making our exports less competitive. This, along with the trade war, has weakened the U.S. manufacturing sector and has put pressure on U.S. economic growth.
In response, the Fed has now lowered rates two times this year and a third 0.25% rate cut is expected when the Fed meets at the end of this month. The U.S. economy is slowing but is still healthy. The unemployment rate of 3.5% is at 50-year low levels. Inflation is low. Interest rates are still low and credit has not tightened. Consumer sentiment is still sound as is small business optimism.
Corporate profits will likely only show small gains this year versus last year weighed down by the energy and tech sectors. Energy profits declines are a result of surplus of production causing energy prices to decline. Tech profits are being impacted by the strong dollar and trade war. Profits are expected to reaccelerate in 2020 as the dollar weakens and the trade war winds down.
Stocks are really not expensive. Earnings are estimated to be roughly $165 for the S&P 500 in 2019. The S&P ended the third quarter at 2,977, so stocks were trading at 18x current year earnings. Earnings are expected to increase to $181 in 2020 so, stocks are trading at 16.4x next year’s earnings. To put this into context, the average forward price/earnings ratio is 15.1x but it rises to 19x when inflation is 1%- 3%. The current inflation rate is under 2% so one can argue that stocks are attractively priced.
There is a lot of pessimism which is understandable given the trade war and events in Washington, but the backdrop is not all dire. On a positive note, there have been fourteen Fed easing cycles since WWII, stocks have been up 12 of the 14 times under these circumstances one year after the second rate cut (notable exceptions 2001 & 2007) with average gains of 18%.
Best,
Michael Kane
