You would think that a non-farm payroll report that was way below expectations would give investors pause. After all, when the pace of employment slows, it usually means that the economy is slowing as well. So why did the stock market spike higher?
It comes down to what the Fed may do. Contrary to many investors’ belief that tariffs (or the lack thereof) are the critical element in the stock market’s fortunes, I believe the actions of the U.S. central bank trump Trump’s antics on the trade front.
A look back to the last quarter of 2018 reveals why I believe this is so. While the press gave plenty of space to the on again, off again China/U.S. trade negotiations, the Fed’s program of raising interest rates is what sent the markets into decline. In December, once the Fed realized that raising rates in an economy that was not overheating was a mistake, they reversed course, announcing any further rate rises were “on hold” until the data dictated otherwise.
From the end of December through the beginning of May, the U.S. stock market rocketed higher, regaining much of its 19% fourth quarter loss, even though no progress had been made on the trade front whatsoever.
Fast forward to last month. Trade negotiations between the U.S. administration and their Chinese counterparts hit a brick wall. Markets dropped more than 5%. Last week, The President’s sudden threat to raise tariffs on Mexican imports by 5% added to the carnage with an additional drop of 2-3%.
While I wrote last week that I doubted (and still do) that those Mexican tariffs would actually be implemented, as of today nothing has changed on the trade front and yet the markets are up considerably. Look to the Fed for an answer.
The threat of new tariffs both in China and now Mexico, on the back of an economy that is growing moderately, triggered concerns that we could be setting ourselves up for a recession as soon as 2020. U.S. Treasury bond prices plummeted and within days investors were speculating that the Fed may need to move off their neutral stance and actually cut interest rates.
Now the market is betting on anywhere from two to three interest rate cuts by the Fed over the next 12 months. That is a drastic reversal of course from a mere six months ago when most believed the opposite would occur (more rate hikes).
Within this context, the jobs report was further evidence of an economic slowdown, which then bolstered expectations that the Fed would need to cut rates sooner rather than later. As such, investors have been conditioned to expect that looser monetary policy by the Fed translates into higher stock prices. It has been the way of the world for the last decade, so weaker macro numbers equate to buy, buy, buy.
As a result, with the Fed at our backs, I expect stocks to continue higher. How high, you might ask? At least to the old highs of the S& P 500 Index (2,944), which is a little under 100 points upside from here. Could it trade even higher? Yes, if the following occurs: Tariffs on Mexico are not levied, some accommodation with China on trade negotiations is made (a mini breakthrough) and/or the Fed makes a stronger statement on rate cuts..
On the downside, second quarter earnings, which are coming up, might not be up to expectations, in addition to further escalation in Trump’s trade war (more tariffs, counter tariffs, etc.). That would not only cap the markets on the upside, but could also establish a rather wide trading range throughout the summer with the lower boundary equating to the recent lows on the S&P 500 Index (2,744).