The first half of 2019 was characterised by the strongest and most broad-based asset price reflation that we have seen since 2009. It is clear that this pace of gains cannot continue through the second half of the year – but there are still grounds for optimism.
Bad news has been good news for stock markets for quite some time. That’s because investors are desperate for a Federal Reserve rate cut in order to keep the equity bull charging ahead. Any negative news is taken as a sign that the Federal Reserve will oblige and good news indicates the opposite.
Last Friday’s jobs report was a clear example of “good news is bad”, as a strong performance in US employment led to a sell-off in equities, as some feared those sought-after interest rate cuts may be delayed.
But now it looks like the Federal Reserve will deliver some of what investors want – and soon. Comments from chairman Jerome Powell this week indicate a rate cut at the end of this month is almost certain. This was rocket fuel for equities and resulted in the S&P 500 crossing the 3,000 level for the first time ever.
Mr Powell said that “uncertainties about the outlook have increased in recent months”. Although he expected continued economic growth in the world’s largest economy, he warned of economic weakness in developed nations around the world and a downturn in business investment driven by the trade war. “Concerns about the strength of the global economy continue to weigh on the US outlook,” Mr Powell said.
As well as giving markets what they are looking for, a rate cut is likely to please Donald Trump, as he has been extremely critical of the interest rate increases that have occurred under Mr Powell’s watch. He believes this has been holding markets back and the president – rightly or wrongly – uses the stock market as a proxy for his economic prowess.
However, the problem is that there may be a little too much optimism over the scale of potential rate cuts. Markets are banking on a substantial sugar rush of cheap money to keep the party going. So much so that traders stepped up bets on a half a percentage point move this month, which seems pretty unlikely.
However, the real problem for President Trump relates to the trade war.
There is some tension between the markets expecting both a US-China trade resolution and at the same time discounting at least four quarter-point rate cuts from the Federal Reserve.
It appears that much of the prospect for rate cuts is linked to the downside risk to growth that will result from an ongoing stalemate on trade. So, if some sort of deal is agreed, it is unlikely that the four rate cuts that currently appear to be priced into equities will actually occur.
The trade war will certainly act as a dampener on the US economy, although so far it has been relatively immune because its size means it is less dependent on international trade than other nations. Combined imports and exports were equivalent to just 27pc of gross domestic product in 2017, less than half the average for all other OECD countries, according to the World Bank.
However, weakness in the global economy is already hitting US manufacturers, which account for about 15pc of its economy. IHS Markit’s US manufacturing purchasing managers index fell to 50.1 in early June, the lowest level since September 2009.
Then there’s US farmers. Not only have they had a difficult year because severe rains have hit the planting season, but revenues have plunged as agriculture has suffered from the tit-for-tat tariffs introduced by Beijing.
The president insists the tariffs are not hurting US consumers and has offered tens of billions of dollars in relief to farmers affected by them. However, if there is no deal with China ahead of next year’s election and tariffs are still in place, there is concern among some Republican strategists that farming swing states such as Iowa and Pennsylvania, which supported Trump in 2016, could be lost.
Politically, a “win” in the trade war could help Donald Trump, but probably will lead to disappointment in equity markets, as the trade and sentiment boost is likely to result in fewer interest rate cuts.
All of this means that corporate earnings will be more important – with bad news in the second quarter reporting season being treated like good news and vice versa. While the first-quarter earnings season was more positive than expected, market estimates for corporate earnings growth continue to decline and reflect weakening economic growth momentum and some downwards pressure on profit margins.
All of this implies more volatility in the months ahead and more moderate returns. However, with bond yields likely to remain subdued and the yield on equities being substantially higher, one of the major props supporting equities remains in place.
Cycles tend to end because of too much exuberance in financial markets, which precipitates overheating in the real economy and results in central banks tightening policy too far.
As we head into the second half of the year, neither of these looks likely to happen – and the US consumer still appears to be in rude health. The rest of the year will be more volatile and gains will be substantially lower than in the first half of 2019, but there are many reasons for optimism.
Garry White is chief investment commentator at wealth management firm Charles Stanley