The Fed Continues to Tweak Interest Rates

By Ketu Desai

As we enter the final couple of months of 2019, the memory of the 20 percent decline in the fourth quarter of 2018 is fresh. While the memory is fresh, there are many important differences between now and then. Perhaps the most important difference is Fed policy. In 2018, the Fed was hiking rates, and was expected to hike another 3-4 times in 2019. Further, the Fed was engaged in quantitative tightening or shrinking its balance sheet. The conditions currently are exactly the opposite, the Fed is cutting rates, and in October, the Fed committed to buy $60 billion a month of short-term Treasuries until at least the second quarter of 2020. The 10YR was north of 3.2 percent last year; it is now sub-2 percent. The easing cycle is global with 40 rate cuts by central banks around the world in the past three months, and that provides a significant backstop for equity markets.

The latest round of earnings has come in better than expected, and there even has been commentary from certain companies that the economy may be reaching an inflection point. For instance, Honeywell's CEO said, “Overall, we're actually not seeing the softening of this environment…what predicts the future is bookings, and our bookings performance was very, very strong." Or the world's largest contract chip-maker Taiwan Semiconductor saying on its conference call that demand is, “very strong". Or Intel's CEO saying, “The tailwinds we see are relatively strong." A wide spectrum of companies ranging from United Technologies, American Express, Paypal, Visa, Microsoft, JP Morgan, Facebook, Starbucks, Apple, GM, Intel, Merck, Pfizer, Mastercard, Citigroup, Lam Research, United Airlines, to Bank of America, exhibited strength in their earnings reports. Overall, 75 percent of companies are beating earnings estimates by an average of 3.8 percent. Another important difference between this year and last is earnings expectations. Last year most were expecting an earnings recession in 2019, whereas, earnings are expected to accelerate in 2020.

The price action between last year and this year is also noticeably different. Last year, the market was primarily driven by defensive sectors such as utilities, REITs, and consumer staples, along with secular growth tech, including software, cloud, and payments. Cyclical groups such as semiconductors, financials, materials, industrials, along with small caps and emerging markets stocks peaked in January 2018, and rolled over coming into the fourth quarter. In recent weeks, the rally has been led by semiconductors, financials, homebuilders - even small caps and emerging markets have performed well recently. The yield curve un-inverting, and strong results from consumer banking, have led to a strong rally in financials, with the financials ETF hitting a 52-week high and names such as JPM hitting an all-time high, and perhaps breaking out. Evidence we may be nearing the bottom of the semiconductor cycle has sparked semis to hit an all-time high, with huge run-ups in names such as AMD, Micron, and Nvidia. The home construction ETF is up 50 percent this year behind low rates and millennial demand. Caterpillar reported earnings that missed significantly on both earnings and revenue, while cutting its guidance, and the stock rallied on the news, which is a microcosm of the current market environment. As investors are rotating into value and cyclical stocks, they are selling defensive sectors such as REITs and utilities. There is a growing belief that the weak manufacturing data is bottoming, and we are starting to recover. If that is the case, 2019 could be the opposite of 2018, a year-end rally led by value and cyclicals.

Looking ahead, the market will continue to digest earnings, and pay close attention to the latest developments on trade.


Ketu Desai is the Principal of i-squared Wealth Management Inc. ( ), an investment management firm based in New Jersey.