Who’s right?

By Guest Blogger Ryan Lewenza

First the important stuff. I have to give a shout out to our Raptors, the 2019 NBA champions! Being a long-time fan and a proud Torontonian, I couldn’t be happier for our team who played their butts off and showed incredible grit, determination and team work. We can all learn something from that team and their season. Now let’s re-sign Kawhi and go back-to-back next year, when we’re all collectively chanting “let’s go Raptors!”

Ok, now on to nerdy market stuff.

Since the beginning of the year we’ve seen a peculiar and unsettling trend of both stock and bond prices moving up together. As seen below the S&P 500 has rallied roughly 15% while the US Government 10-year bond yield has declined from 2.9% to 2.1% (bond prices move inversely to yields) or over 25%.

Normally you see bond prices declining as stocks rise since the economy is generally strong causing the Fed and other central banks to hike interest rates. This time it’s different with both moving up together resulting in conflicting messages from the stock and bond markets. Stocks are suggesting more growth while bonds are signaling a slowdown/recession. Which one will prevail?

Stocks and Bonds Are Rallying. Who’s Right?

Source: Bloomberg, Turner Investments

Why are bond yields declining?

I believe it’s largely due to two factors – recent weaker US/global economic activity and Trump’s ongoing trade war with China.

Look at the chart below. I overlaid the ISM manufacturing index – a great leading indicator of manufacturing activity in the US – with the US 10-year yield. Note the strong correlation and recent declines in both. This chart illustrates that the decline in bond yields is being driven by softer economic data. The key question is what is driving this (Trump’s trade war or just a natural slowdown in the economy) and what will the Fed do in response to this economic soft patch?

Bond Yields Are Down On Slowing Economic Growth

Source: Bloomberg, Turner Investments

Will the Fed cut rates?

What a 180 degree turn from late last year when the Fed was signaling that they would continue to tighten monetary policy and hike rates further. Many economists were calling for 2-3 rates hikes this year (I was on record saying one and done for this year) and now the market is pricing in 2-3 rate cuts. Currently Fed Funds futures are implying an 84% probability of a cut at its July meeting.

Either the economy has slowed more than the Fed expected or Trump’s ongoing threats to Fed Chairman Powell are having the desired effect leading the Fed to backpedal faster than the NBA sportscasters who said the Raptors had no chance against the Bucks and Golden State!

I believe the pendulum has swung way too far to the bearish side. The fact remains that the US/global economy is still in decent shape. For example, the US unemployment rate stands at a 60 year low. If that doesn’t suggest a strong economy then I don’t know what does?

I see economic data stabilizing and bond yields starting to move back up as investors realize they overshot and the economy is not going to hell and a hand basket. Plus I continue to believe a US/China trade deal could be hashed out as it’s in everyone’s best interest and Trump will want a big win ahead of the 2020 election.

Given this I see the Fed cutting at most once this year and it’s more of an insurance policy rather than a signal of a more protracted downturn.

Fed is Expected to Cut Rates at July Meeting

Source: Bloomberg, Turner Investments

What does this mean for the stock market?

To me both scenarios are bullish for the stock market. Either I’m correct on the economy and it stabilizes, which would be bullish for corporate profits and the equity markets overall. Or I’m under-appreciating the slowdown in the economy and impact of Trump’s escalating trade wars, in which case, the Fed will cut rates more than I expect thus are adding more stimulus and support to the stock market.

We used to talk about a Greenspan or Bernanke Put on the markets (they would cut rates to support the stock market). Now it looks like we have the Powell put! And the one thing I’ve learned about the markets and investing, it generally does not pay to bet against the Fed. So just like we said earlier this year, block out the noise and position portfolios for more upside, but do so with more defensive investments like high-quality dividend payers and healthcare stocks just in case I’m wrong. It does happen from time to time.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.