Economic and market perspective
Receding trade tensions and expectations of further monetary policy easing globally were in focus in September as global data continued to weaken, while U.S. economic data quietly improved.
Despite U.S. tariffs on $125 billion worth of Chinese goods as well as Chinese tariffs on $75 billion of U.S. goods taking effect on the first of the month, overall trade tensions eased in September. The U.S. and China agreed to a 13th round of trade talks set to begin in October and the U.S. agreed to a modest delay on the next round of tariffs from October 1st to October 15th as a “goodwill gesture.” Both sides announced exceptions to their respective lists of goods subject to tariffs.
Chinese industrial output rose 4.4% in August, the lowest monthly gain in 16 years. Eurozone PMI declined to 45.6 in September from 47.0 in August, reflecting the worst European manufacturing data in seven years. German manufacturing data declined further to 41.4 from 43.5, it’s worst level in more than ten years.
The U.S. Institute for Supply Management (ISM) manufacturing index released today for September declined to 47.8 from 49.1 in August, the first back-to-back contraction since early 2016. The ISM non-manufacturing index for August was stronger than anticipated at 56.4 and is expected to show continued growth for September when released on October 3rd.
On September 12, the European Central Bank (ECB) announced that it would lower its deposit rate from -0.4% to -0.5%, in line with market expectations, and that it would reinitiate bond purchases at the rate of €20 billion a month. The ECB stated these purchases are set to begin in November and “run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it starts raising the key ECB interest rates.”
Third quarter corporate earnings in the U.S. are expected to decline (-3.8%) according to FactSet. If this were to occur, it would be the first time period with three consecutive quarters of year-over-year earnings declines since the beginning of 2016. A rebound in earnings (+3.0%) is expected for the fourth quarter that would bring full year earnings growth to 1.3%. That rebound is expected to carry into the first quarter (+7.9%) and second quarter of 2020 (+9.0%) with full year 2020 earnings growth projected at 10.6%.
Outlook and conclusions
The Federal Open Market Committee cut the Fed Funds rate by 25 basis points at its September 17-18th meeting, in line with market expectations. The 25 basis point cut brought the range for the Fed Funds Rate to 1.75% – 2.00%. Despite referring to the July rate cut as a “mid-cycle adjustment,” the Fed cut rates for the second consecutive meeting. The cut announcement was noteworthy for the three dissenting members – two voted against a cut and one voted in favor of a larger cut. The newly released ‘dot plot’ reflected the median Fed member expecting no further cuts this year, but a plurality of members expected Fed Funds to end in the 1.50% – 1.75% range, 25 basis points below the current range. The market is pricing in a 39% probability of an additional rate cut at the Fed’s October 29-30 meeting and a 72% probability of a rate cut by the December 10-11th meeting.
The Fed provided up to $75 billion nightly of additional liquidity into overnight repo markets in mid-September, the first time in a decade the central bank has had to infuse liquidity into sector. The Fed plans to continue to make these funds available through October 10th and “as necessary” thereafter to maintain the federal funds rate within its target range. Additional cash needs are typical at quarter-end for corporate quarterly tax payments, but the magnitude of the cash shortage that briefly pushed short-term rates to above 10% is what attracted market attention. Bank reserves held at the Fed have declined nearly 50% to $1.5 trillion over the past 5 years. This decline has been partially blamed for the crunch.
The U.S. financial markets were largely able to overlook what proved to be a volatile month on the geopolitical front. Following an impeachment inquiry launched by the house into the President of the United States, attacks on global oil infrastructure, British opposition parties meeting to formulate plans to block a no deal Brexit and continued rumblings on the U.S. China trade dispute, markets have been able to overlook the noise and focus instead on overall economic activity. Risk appetite for U.S. fixed income assets remains robust. U.S. credit spreads are largely in-line with our view on corporate fundamentals and remain supported by accommodative monetary policy. While it is difficult to say fixed income is cheap at current valuations, neither can we frame U.S. fixed income assets as expensive. As a result, we have recently taken a more benchmark neutral stance on portfolio construction. We continue to believe U.S. fixed income will remain supported by relatively strong economic activity in the U.S. as well as broader demand from overseas investors who continue to face negative yields in their home markets.