The Federal Reserve meets this week on June 18-19 to discuss interest rate policy. Investors overwhelmingly believe that not only will its next move be a reduction in the Fed Funds rate, but that two rate cuts are in the hopper by year end. How much easing does the economy need? From our perspective, not much. Q1 GDP expanded 3.2 per cent year-over-year, among the fastest paces recorded over the last decade. The labor market is on fire: the unemployment rate, at 3.6 per cent, is at a 10-year low. Wage growth is in its top decile as well. Confidence among both consumers and businesses is strong.
It’s the Sino-American tariff tiff that’s upsetting the economic apple cart, prompting manufacturers to downshift to low gear. Hiring in the manufacturing sector has flatlined over the last four months as employers look for clarity. The ISM Manufacturing Index has slumped to its lowest level since 2016. To investors it’s a trade dispute, but the gulf between the two largest economies runs much deeper. Presidents Trump and Xi are set to meet at the G20 Summit in Osaka, Japan next week. Tariffs, the only tools President Trump has at his disposal, are the blunt instruments the administration has deployed to challenge China’s quest for global dominance in technology and biotechnology. The odds of a quick reconciliation are remote.
How much easing does the equity market need? In our view, much more than the economy needs. Equity investors have feasted on aggressively low interest rates in recent years and companies, fueled by cheap financing, bought back their shares at record rates. Since Q4/06, S&P 500 earnings per share plus dividends per share (a proxy for profit) has expanded at more than twice the rate of net income, thanks to a reduction of shares outstanding. Investors need ever-cheaper financing to keep share buybacks on track. That’s why investors are browbeating the Fed to lower rates.
It’s hard to tell whether the Fed will eventually cave to investors’ demands. A disappointing outcome in Osaka next week, however, would likely prompt the Fed to act at its July meeting. In an environment in which bad news is good news, the net effect could be positive for an equity market looking for its next shot of liquidity.