US equity markets established new all-time highs this week as the S&P 500 crested over 3,000 and the Dow exceeded 27,000. Asset markets are ascending as testimony from Fed Chairman Jay Powell further reinforced an already entrenched market conviction that the Fed will cut rates at the end of July and start the next easing cycle. Fed Fund futures are not only pricing in certainty of a cut at the next meeting, but a 25% chance that it could be 0.50% instead of the standard 0.25% increment – a so-called “insurance cut.”
Chairman Powell stated that wage growth of 3% is not high enough to outpace productivity growth and inflation, therefore the job environment cannot be described as “hot” despite low levels of unemployment. This is a monetary policy push to raise inflation yet again and the 10-yr Treasury yield responded, albeit only modestly rising above 2.1% from near 2%. With short-term rates on the decline from a top of 2.5%, there is likely a cap on how high long-term rates can go until realized inflation numbers say otherwise.
While history is no sure-thing, it does suggest that equity markets can continue to do well for a while longer when Fed Funds cuts are in the cards. Lower rates help traders rationalize higher price-to-earnings (P/E) multiples and that is what is happening. Negative earnings revisions the past few months and higher stock prices have led the S&P 500 to an estimated 18x P/E multiple. While that is above average historically, valuation is a terrible timing tool and thus is no indication of market direction over the next few quarters. Earnings expectations finally stabilized in June and should any one of the factors leading to global uncertainty (China trade, Brexit, Iran, etc) have even a short-term resolution there is no reason why equity markets could not follow historical patterns and march higher.
Meanwhile, the other thing going up is the deficit. In a report released Thursday, the US budget deficit increased 23% to $747 billion in the first nine months of the fiscal year (October 2018 through June 2019) as compared to the year before. Expectations are for the full-year deficit to be between $900 billion (Congressional Budget Office) to $1 trillion (White House). While government budget deficits are typically funded through more bond sales, the US government has been stuck at the debt ceiling since March with the Treasury Department using their accounting flexibility to meet obligations. Treasury Secretary Mnuchin indicated that the US will run out of cash to pay its bills without an increase in the debt ceiling by September. History would suggest that the debt ceiling will go up too.
While the common saying “what goes up, must come down” does not necessarily apply in financial markets, we are mindful to stay steady in our financial plan, stay balanced, and stay quality. Participating in the asset lift up is good; being prepared to take advantage when opinions change is better; having the financial durability for the many cycles to come is best.