2019 is the year of the pig, according to the Chinese Zodiac. For investors in the U.S. stock market, however, it has been the year of the bull. The S&P 500, which is at an all-time high, is up 18% year-to-date, catalyzed by gains in all 11 sectors.
The health care sector, up 8.4%, is the only sector that hasn't registered a double-digit percentage gain, underscoring the point that market participants have been less discriminating in their buying efforts.
It has been a remarkable rally indeed, as it has occurred in the face of some remarkable uncertainty regarding U.S. trade dealings with China, recurring signs in the economic data that global growth is slowing, and downward revisions to earnings estimates.
What is it, then, that has gotten the stock market so fired up? It has been easy monetary policy and the prognostication that it is going to get even easier in the months ahead, not just in the U.S. but around the globe.
The second quarter has been a roller coaster for the stock market. April was another good month, but then May happened.
The S&P 500 declined 6.6% in May. Things began on a sour note when Fed Chair Powell and the FOMC left the impression coming out of the April 30-May 1 meeting that the FOMC wasn't inclined to cut the target range for the fed funds rate anytime soon.
Notably, the Fed chair didn't imply that the FOMC would be raising the target range anytime soon either, yet the stock market revolted, bothered by a flattening/inverted yield curve and the notion that weakening economic data should be motivating the Fed to take back its December rate hike and be proactive with a more accommodative monetary policy.
Adding insult to stock price injury, President Trump shocked the world with an announcement that the U.S. would be raising the tariff rate on a $200 billion tranche of imported Chinese goods to 25% from 10% and would be exploring the implementation of a 25% tariff rate on another $300 billion of Chinese imports.
That announcement was sparked by the president's frustration with China for reneging on trade deal provisions it had reportedly agreed to previously. China said it did no such thing and that it didn't appreciate the U.S. administration's bully-like negotiating tactics.
In a nutshell, the trade deal between the U.S. and China, which the market had come to think would soon be a done deal, unraveled. Verbal barbs were traded in the press and it became apparent that China was preparing to dig in for a protracted fight if need be.
The trade angst got dialed up a notch at the end of May when President Trump shocked the world again with an announcement that the U.S. would impose a 5% tariff on imported goods from Mexico, with an escalator to 25% by October 1, if Mexico didn't do more to stop the flow of illegal immigrants into the U.S.
The tariff threat against Mexico was ultimately averted, which made the market feel better, yet the real cure came on June 4 when Fed Chair Powell said at a conference in Chicago that the Fed will act appropriately to sustain the expansion.
The stock market ran strong with that news, as it was deemed to be a dovish-minded tilt in the Fed's thinking that would result in an interest rate cut happening sooner rather than later. For good measure, Presidents Trump and Xi later reduced some of the trade deal worries when they said they would hold extended talks at the G-20 Summit at the end of June.
While there is understandable angst surrounding the trade issues, the chart below clearly shows how easy(ier) monetary policy considerations are driving things in the year of the pig. As of this post, the S&P 500 was up 7.8% since June 3 and up 18% year-to-date.
The Federal Reserve wasn't the only rate-cut game in town in June. The ECB, the Bank of Japan, and the Reserve Bank of Australia all dangled the possibility of providing more accommodative monetary policy.
That was truly extraordinary in the case of the ECB and the Bank of Japan, which have espoused policies that include negative rates already and have led to negative-yielding bonds. In fact, Bloomberg data cited by FT indicates that there are approximately $12.5 trillion of bonds globally with negative yields.
The 10-yr Japanese government bond yield is -0.17% and the 10-yr German bund yield recently hit a record-low -0.32%. Buyers of those securities are literally paying the Japanese and German governments to borrow their money.
That messed-up distinction has been instrumental in driving down Treasury yields, which are low in their own right but relatively high compared to the sovereign bonds of many other developed countries.
The 10-yr Treasury yield recently hit 1.98% -- 70 basis points lower than where it started the year and its lowest level since late 2016. That's a stunning development for myriad reasons and also a confounding one since that low yield goes hand-in-hand with a dour economic outlook, and yet the stock market is at an all-time high led by gains in the cyclical sectors.
The understanding that corporate credit spreads haven't blown out simultaneously, though, has taken some of the edge off the slowdown argument. Corporate spreads can widen in a hurry, yet their well-behaved nature at this time is supporting the idea that the inverted yield curve isn't a harbinger of a recession so much as it is a function of searching for yield in a low-yielding world.
Eye on the Consumer
Signs of a slowdown, though, are emerging in manufacturing surveys, business confidence readings, and business investment data.
The consumer, supported by constructive labor market conditions, is still in reasonably good shape. That's no small consideration knowing that consumer spending accounts for roughly 70% of U.S. GDP. Still, if business confidence and business spending continue to deteriorate, it stands to reason that there will be a pickup in jobless claims that will weigh on consumer sentiment and consumer spending.
Undoubtedly, consumer-oriented data will be a focal point in the second half of the year.
The enthusiasm for accommodative monetary policy right now is predicated on the belief that low policy rates will buy time to get economic growth and earnings estimates turned around. If the data - and the consumer-oriented data in particular -- disappoint on a regular basis, there is going to be a nettlesome conclusion that monetary policy at this juncture is tantamount to pushing on a string.
The Federal Reserve, and other central banks, can ill afford that conclusion, especially since it would be preceding an actual recession when monetary policy is typically looked upon as a fix for turning things around.
That bridge hasn't been crossed yet, but it will definitely be a toll bridge if the market gets there.
Moral Hazard in the Mix?
The stock market for its part is on a road right now that it believes is paved with good intentions on the part of the world's major central banks.
Keeping policy rates low -- or lowering them further -- is an approach that has certainly borne fruit for the U.S. stock market, but to be fair, strong earnings growth and accelerating economic activity have also been instrumental in producing that fruit.
The crossroad today is that there is little to no earnings growth and economic activity is decelerating. Still, there has been multiple expansion on the back of falling interest rates, and, dare we say, moral hazard.
Currently, the S&P 500 trades at 16.9x forward twelve-month earnings. That's above the 5-year and 10-year averages of 16.5x and 14.8x, respectively, according to FactSet, but it's not an egregious valuation given where interest rates are.
The forward earnings yield of 5.9% is nearly 400 basis points above the risk-free rate, or nearly 30 basis points above the 5-year average. Relative to bonds, stocks still appear to hold better value.
What It All Means
The road ahead for the stock market will require some careful navigation. A lot of good news has been priced in already along with a lot of faith in the Fed put.
Furthermore, the political environment is going to be more challenging. That includes the trade deal negotiations with China, the saber rattling with Iran, the budget and debt ceiling negotiations between Congress and the White House, and the emergent 2020 presidential campaign.
The stock market also has a lot riding on the Fed delivering with an easier monetary policy. Remember, the S&P 500 is up 18% this year before the Fed has even cut the target range for the fed funds rate.
The stock market has feasted heartily on the persistence of low interest rates and the belief that rate cuts are coming, but with an 18% gain on little to no earnings growth in a weakening economic environment, it is evident that future gains have been pulled forward.
In the year of the pig, then, it is worth repeating that pigs get fat in the stock market while hogs get slaughtered. Enjoy the feast while it lasts, just don't get too greedy in a market that has fattened up on a smorgasbord of rate-cut expectations.