By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
We think recent data is setting the stage for the U.S. Federal Reserve (Fed) to pause their rate hikes. This shift in future policy could be embedded in the language from the next Fed policy announcement following its December 19th meeting, and could be the catalyst for a stock market rally.
Our economic models and analysis suggest that the pace of economic growth in the U.S. has peaked. For instance, the latest readings of real and nominal GDP growth reflect a declining growth rate. We prefer to focus on nominal GDP due to its inclusion of inflation and its relationship with corporate revenue growth and long-term interest rates. We expect both measures of economic growth to continue to decline towards their long-term trend in the quarters ahead for a variety of reasons.
First, some of the recent drivers of economic growth have already begun to slow. Manufacturing PMI and export growth still reflect positive growth rates, but at a slower pace than in recent quarters. Manufacturing output continues to expand at a solid pace, but the combination of the slowdown in global growth and the sharp fall in crude oil prices, among other factors, are likely to weigh on economic activity in the coming months. For example, the steep decline in oil prices suggests that drilling activity will decline going forward until prices stabilize.
Additionally, the residual effects from strength in the U.S. dollar will likely weigh on exports in the near-term. As Fed policy tightens with rate increases relative to other central banks, it creates upward pressure on the U.S. dollar and a headwind to export growth while the positive effects from fiscal stimulus, such as corporate tax cuts, fade and diminish domestic activity.
Finally, we think the collective yawn by the bond market in response to faster GDP growth in previous quarters confirms this view. If accelerating growth were to persist, long-term yields and market-based inflation expectations should have risen further in our opinion, yet these measures have begun to decline as well.
For example, market-based inflation expectations, such as the difference between Treasury Inflation Protection Securities (TIPS) and the yield of regular U.S. Treasury securities with the same maturity dates (the TIPS spread), has declined from recent highs. The TIPS spread peaked below the July 2014 high when jobs creation topped, and GDP was running as 5.1% annualized in Q2 2014 and 4.9% annualized in Q3 2014 compared to the most recent readings of 4.2% in Q2 2018 and 3.5% in Q3 2018. The bond market seems to be suggesting that the burst in GDP growth will fade.
Although these events do not sound particularly constructive, they may foretell some positive things to come. A slowing in the pace of economic growth and inflation is relatively good news in our opinion because we think that it will cause the Fed to scale back its planned interest rate hikes before they cause the yield curve (the difference between long-term and short-term interest rates) to invert, choke off liquidity, and maybe even cause a recession next year. We expect the Fed to raise interest rates one or two more times and then pause, which should allow slow growth to continue. In fact, we think that the current economic growth can continue for at least another year, and probably longer.
The CME Group FedWatch Tool, which measures market-based expectations for future Fed rate hikes, has recently shown a decline in the probabilities of more than two rate hikes from this point. Judging by this measure, it seems that the market is moving towards our expectation for the pace of rate hikes to slow.
Slowing economic growth may cause some market volatility or even a correction, but we think the real risk to equities is a recession. With little risk of recession on the horizon, many companies can grow revenues and earnings in a slow growth environment, which can support higher stock prices. Historically, equity prices peak about six months before a recession. With minimal risk of a recession in the near-term, our work suggests that equity prices can make new highs.
There are some strong fundamental trends that point to continued, albeit slower, economic growth. For example, global leading economic indicators suggest relatively muted global growth. Even though the vast majority of U.S. economic activity is based on the domestic economy, slowing global growth should create a headwind to U.S. growth. Meanwhile, personal income continues to slowly but steadily grow, up almost 5% since last year, along with personal spending. Finally, we expect jobs creation in the U.S. to remain above the approximately 100,000 new jobs per month that is required to keep pace with the estimated growth rate of the U.S. labor force. This should provide a positive feedback loop for consumer income and spending.
The combination of the stock market selloff and positive earnings growth has pushed the forward price-to-earnings ratio for the S&P 500 Index below its 5-year average. We think that this creates a good opportunity to purchase high quality assets, and a shift in Fed policy could provide the impetus for stock price appreciation.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
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