Priced for perfection
Author: Kevin McCreadie
May 13, 2019
Equity markets have rallied to new all-time highs again this spring, but the two key assumptions driving stocks up – a signed trade deal between the United States and China, and rate pause, if not cut, from the U.S. Federal Reserve – are far from guaranteed and may not pan out exactly as expected.
Case in point is the abrupt turn in trade negotiations between the world’s two biggest economies. For weeks, investors acted as if an imminent deal between the U.S. and China was a sure thing – only the Ts needed to be crossed and Is dotted. However, that’s no longer the case and tensions have once again escalated with the U.S. hiking tariffs on Chinese imports and China retaliating.
While this could be nothing more than the latest strong-arm negotiating tactic in the drawn out affair, it has ruffled feathers, leading to an increase in market volatility this month that is tough to ignore. And even if a deal is eventually reached – and that still seems most likely – the chance that tensions flare further and contribute to more uncertainty in the days and weeks ahead is real.
“If a deal is eventually reached – and that still seems most likely – the chance that tensions flare further and contribute to more uncertainty in the days and weeks ahead is real.”
Whether that’s enough to capsize the recent rally may also depend on the Fed’s next steps. At last count, there is unanimous agreement that the U.S. central bank will not raise rates this year, with odds of a rate cut still north of 50%. This despite recent comments from Fed Chairman Jerome Powell that there is not a strong case to cut or hike rates at the moment.
So, who’s right? The potential of a rate cut may have a lot to do with the fact that central bank reserves have dwindled and could result in tighter conditions if not counteracted. The real key, however, is the state of the economy and inflation rate. At least for now, signs of economic weakness have subsided and, with the 10-year U.S. treasury yield now roughly 75 basis points lower than late last year, the current backdrop may be enough to spur on more spending in areas like the housing market without having to cut rates further.
At the same time, inflation may not be as benign as proponents of a rate cut claim. Yes, core price levels have fallen further below the Fed’s target inflation rate of 2% this year, but by definition this doesn’t account for food and gasoline prices, both of which are on the rise.
In part, this omission makes sense. Gasoline prices can be volatile and move up and down frequently based on the underlying price of oil, but higher food prices are more likely here to stay. The price of a cup of coffee, for instance, goes up when coffee bean prices do, but when do you ever see the price of a cup fall when bean prices are headed downward?
Similarly, the price of pork is expected to climb from the African swine flu epidemic in China that is forcing the country to kill off one quarter of its 400 million pig population. But restaurants who raise their prices because of it aren’t likely to lower them sometime down the road.
Aside from this argument, the Fed still has to weigh the prospect of wage growth as it contemplates its next move. One of the most surprising elements of this economic cycle has been the conspicuous absence of fatter paycheques despite months of record low unemployment rates. Eventually, though, higher wages could be a real deterrent to lowering rates and even swing the Fed’s thinking towards another hike.
If anything, there’s nothing that investors should take for granted. Stocks may climb from here, but at this stage in the earnings growth cycle, even the slightest deviation from what’s priced in could result in a setback.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives.
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