Last week at around this time, the markets appeared to be signaling something ominous. At the very least, it was becoming evident that an economic slowdown was in the cards. The yield on the 10-year Treasury bond had dropped to a more than 5-month low of 2.17% from as high as 2.63% in mid-March; stocks continued in a malaise that began in early March and saw the S&P 500 drift lower by about 2.5%; the dollar continued in a downward trend that started in early April; and gold continued a steady rise that resulted in nearly an 8% gain over a five-week period. Moves like these don’t happen unless there is some fear out there.
What caused the sudden fear? As we explained last week, a confluence of factors – weaker economic data, geopolitical concerns, and fiscal/monetary policy uncertainty – were enough to thrust the markets into “risk-off” mode. We posited that this confluence of factors could conceivably be enough to keep the Fed on the sidelines for the remainder of the year, and we provided the data to show that the markets were beginning to agree. Specifically, we showed that as of April 19, the odds of no additional interest-rate hikes through the remainder of the year had increased to around 24% from around 11% on April 7. However, we also stipulated that this scenario (no more rate hikes this year) carried one vital caveat. We said that Congress would need to continue to make little progress toward implementing any of the “pro-growth” initiatives that the new presidential administration has been championing.
Fast-forward one week and VOILA!, everything is right with the world again. The catalyst? President Trump announced his intention to seek a cut in the corporate tax rate to 15%, which is the low end of previous discussions. Not only does Trump want 15%, but it appears as though he is willing to cut rates without the preconditions of: 1) health care reform; and 2) new tax revenue to offset the proposed tax cuts (which means the President needs only 51 votes in the Senate rather than 60). And one more bonus: it also appears as though the President is willing to punt on the Mexican border wall for now, reducing the odds of a government shutdown later this week. Each of these “concessions” improves the odds of that magical word “stimulus” that the markets love to hear. There’s nothing like a nice, healthy dose of stimulus to get the markets going in the right direction!
In the chart below, you can see that we have reverted back to roughly the same odds of interest-rate hikes that prevailed earlier in the month. Based on these figures, it is now much less likely (~10%) that the Fed will stand pat through year end. It seems that tax cuts will boost economic activity and allow the baton to pass from the Fed to Congress. Crisis averted!
While it’s probably obvious that we think the markets have an unhealthy dependence on stimulus, there are also some additional developments that have supported stocks and other risk assets for the first two trading days of this week:
- The dollar has continued to weaken, which supports US exports, domestic economic growth and profits for US multinational corporations;
- It appears as though China may be using its influence to reduce tensions between North Korea and the US;
- There has been no further fallout from the US bombing of Syrian regime assets;
- The recent bounce higher in interest rates is good for the banking sector, which has been waiting for years for higher interest rates;
- The French election results mean that it is less likely that France will attempt a Frexit, which could result in the dissolution of the EU;
- Earnings results have been coming in better than expectations (as usual due to sandbagging)
While last week’s fears were probably overblown, this week’s optimism probably is too. We are still a long way from the Trump administration getting its way on taxes, infrastructure spending and other “stimulus” initiatives. The best investors are able to control their emotions. We remain defensive but fully invested.