Dalton — Last week the Fed cut the federal funds rate by one-quarter of a percentage point, which was widely expected. This was the second such cut in as many months. The next policy meeting will be in October and the odds of yet another cut, as measured by the federal funds futures market, are about 50/50 — standing at a 43% chance now compared to a 100% probability for this last one. Prior to the first cut, in July, I’d have argued that the chances of three one-quarter percentage point cuts were less than 50/50. However, in the most recent post-meeting statement, there was plenty of dovishness, noting, for example, that “uncertainties about the outlook remain. Some Fed officials want another cut this year, and others could be convinced to do so if the economic data weakens. The Fed has continued to repeat the line that any decision made — cut, stay or hike — will be “data dependent.” But outside of building and moving things (the manufacturing and freight sectors have been weak), the data has been good. The Atlanta Fed GDPNow estimate of gross domestic product for this quarter is almost 2% (the Blue Chip consensus is right at 2.0%). The hard data, such as jobless claims, housing starts and retail sales look good and don’t warrant so many, if any, cuts. Is the Fed doing the right thing? I think so. There is a lot of good, but we keep seeing weakness.
As indicated, the manufacturing sector is awful right now. Manufacturing makes up about 12.5% of U.S. GDP (truck transportation makes up about 1% of GDP). It’s not the driver of our economy, but it is large enough to tilt us one way or another. But the hard data isn’t my biggest concern. My biggest concern is the soft data, sentiment about the direction of the economy. We humans think about things, then we do things. It makes sense that we’d first feel cautious about the direction of the economy, then make a decision based on that sentiment. In other words, thoughts lead to actions. And the thoughts of the nation’s CFOs are negative. On the same day the Fed cut rates, Duke Fuqua’s latest CFO survey was released. The CFO Optimism Index, which has historically been a predictor of hiring and GDP growth, fell again this quarter to its lowest level since September 2016. That doesn’t sound too bad, but remember, better or worse matters more than good or bad. More than half (53%) of U.S. CFOs think we’ll be in a recession by the third quarter of 2020, and more than two-thirds (67%) expect us to be in a recession by the end of 2020.
Per the survey, “economic uncertainty has displaced difficulty hiring and retaining qualified employees as the top concern among U.S. CFOs.” There is good news, as the survey goes on to point out that: “there is one moderately bright spot. Companies continue to want to hire to fill certain job positions. Job titles that have the most opportunity right now include engineers, machine operators, manufacturing technicians, medical technicians, and sales.” It’s hard for me to reconcile the prediction of a recession coupled with a strong desire to continue hiring. I mean, it’s hard to reconcile the planning. I get the human part of it — CFOs can’t have the employees they want, and you want what you can’t have. CFOs still want to hire, even if their need will be less a year from now. Still, it stumps me. I’m not sure if the additional hiring will keep the expansion going longer or if a slowdown will be exacerbated because companies will be burdened with higher payrolls. Given the reduced economic activity due to Brexit considerations and the U.S.-China trade war, I’m guessing the recession comes and then companies must deal with the cost of bloated payrolls.
Stock market performance after second rate cuts
The Fed cut rates in July and then, in September, did so a second time. Historically, after a second cut, the Dow Jones Industrial Average has been up an average of 12.13% six months later and 20.26% one year later. In non-recession cases, the Dow has gained more over six months than in recession cases (13.8% vs. 11.2%). One year later, however, gains have been stronger in recession cases than in non-recession cases (21.5% vs. 18.2%). This is comforting news, but the monkey wrench is that in most cases, the Fed has waited until near the end of the recession before beginning to cut. In those cases, the Dow bottomed about a month before that second cut. This time around, the market is flirting with all-time highs at the time of the second cut.
With the market doing so well currently, I don’t think the stock market will get as much fuel out of these cuts as the historical averages suggest. The more likely historical analogs will be based on binary outcomes — either that the cuts will keep us out of a recession, or not. If the Fed keeps us out of recession, the historical average gain for the Dow in that scenario is 18.2% after the second cut. If the Fed fails and we enter a recession in the next 12 months, the average loss has been -10.8% one year after the second cut. I’m with the Duke Fuqua CFOs: I think we’re going into a recession, which means the stock market has a good chance of being lower a year from now.
My (two second) thoughts on Brexit
It has been more than three years since the British voted to leave the European Union and a resolution still seems that far away. What is my best guess as to what’s going to ultimately happen? It is a tale told by an idiot, full of sound and fury, signifying nothing Shakespearean talk aside, I’m beginning to think it’s never going to happen. That sounds like a flippant remark, but I’m being serious. Sure, former Prime Minister Theresa May came up with an agreement the EU leaders accepted before the initial March 31, 2019, deadline, but the UK Parliament voted it down three times.
It’s now in the hands of new Prime Minister Boris Johnson. He’s been vocal about the idea of allowing a hard Brexit to occur if no agreement is met by the Oct. 31 deadline. I don’t believe him. There is a Brexit EU summit scheduled for Oct. 17-18, and even if Johnson renegotiates a deal with the EU leadership that is more likely to be accepted by the UK Parliament than the current one, it’s not a slam dunk. Johnson’s Conservative Party recently lost its Parliamentary majority, and several members want to put the vote back to the people, arguing that, to put it plainly, Brexit is a stupid idea.
I think Brexit will be delayed again and again, as Parliament continues to fail to ratify a plan. The uncertainty will weigh on the nation, its economy and its citizens will suffer, and eventually there will be a decision, or a vote, to drop Brexit altogether.
If I’m wrong at all, the next most likely scenario will be a hard Brexit on Oct. 31, in which case I’ll owe Boris an apology for not believing him. I’m not going to get into all the details, but the gist of it will be that the supply chain between the UK and the EU will be busted up because nobody is ready to deal with it, because nobody believes a hard Brexit will happen. If it does, the UK will go into a meaningful recession that will hurt the EU and be negative for the U.S.
This article originally appeared in The Berkshire Edge on September 24, 2019.