Since our last note to clients, the S&P 500 has rallied approximately 10%. In our last note to clients we suggested fresh all-time highs to be reached by stocks in the upcoming weeks. Indeed, that is what this rally has led to. Furthermore, we expected the Fed to cut rates at the end of October and leave them unchanged in December, which they did. The stock rally and the Fed’s policy are inextricably tied together.
As I write this, the S&P 500 is up 36% from the December 24, 2018 low. We are only a few percentage points away from having the best-performing stock market for a calendar year since 1997. This is a pretty amazing statistic but not one we are too surprised by. This is a long way from where investor sentiment stood at the end of last year. Understanding the difference between the Federal Reserve’s policy stance 12 months ago versus today is key to understanding why stocks have rallied….and will continue to rally through 2020. Understanding the basis for the Fed’s shift in policy is key to understanding why a recession in 2021 is very likely to occur.
For decades, the Fed has used the unemployment rate as a key indicator for where inflation is headed. If unemployment decreases, then inflation risks increases. The Fed wants to prevent inflation from leading to price instability. This means the Fed will typically raise rates when unemployment declines to help keep the economy from “overheating.”
Since the Financial Crisis, the Fed has been far more worried (correctly so) about deflation than inflation. Deflation is much more damaging to the economy than inflation. Inflation means the economic “pie” is expanding, but too rapidly. Deflation means the economic “pie” is shrinking rather than expanding. Neither is welcomed but deflation is far more devastating than inflation. Think of the Great Depression as the last best example of what deflation can lead to. Think of the recessionary 1970’s as the last best example of what inflation can lead to.
Since 2016, when the Fed first raised rates following the Financial Crisis, the Fed has thought the threat of deflation was behind it. This belief is what led the Fed to raise rates 9 times since 2016. It is also what led them, as late as October 2019, to set the stage for 4 more rate increases in 2019! Well, it seems, this was a false sense of security on the part of the Fed.
As is frequently the case, the Fed takes one step too far before recognizing its mistake. In this case, the rate increase in December 2018 was that “one step too far.” Thankfully, the Fed realized its mistake quickly and reversed course. Within days of the December 2018 rate hike and within weeks of setting the stage for multiple rate hikes in 2019, the Fed completely reversed course. Instead of raising rates in 2019, the Fed has cut rates 3 times. A stunning change in policy but not one without precedent. The Fed did something very similar in the mid-90’s which also turned stocks higher. Will the Fed’s accommodative policy send stocks even higher? We believe so……at least through 2020.
In addition to 2019, the Fed has cut rates 3 times in a row by 25 bps (1/4 of a percent) in 1975, 1996 and 1998. Below we look at how stocks have performed following these cuts. While past performance does not predict future results, we do expect stock returns to move higher over the next 12 months. Fed policy is a major influence on our view.
Source: LPL Financial
Moving to politics, the march toward impeachment has had little, if any, effect on stocks. We expected the House to pass the articles of impeachment. We also expect the Senate to acquit the President. This would be the same outcome as we saw during President Clinton’s impeachment vote. So, how did stocks perform during the Clinton impeachment?
Between the House vote to impeach President Clinton and the beginning of the Senate trial (December 19-January 6), stocks gained over 6%. During the Senate trial (January 7-February 12) stocks declined by 3%. Following President Clinton’s acquittal, stocks gained almost 20% for the remainder of 1999. So, stocks performed pretty well during the impeachment of President Clinton and through the rest of 1999.
Will a similar gain-decline-gain rhythm play out for stocks during this impeachment process? We think so. It makes sense to us that steam will run out of the stock market at the beginning of the year but only for a brief period. This might have been our view regardless of whether an impeachment was taking place. However, given the strong end-of-year rally and the weight of a Senate trial of the President, it is likely stocks will take a breather.
As we prepare for the possibility of a mild sell-off, we have raised cash in our managed accounts. We expect to invest this cash in stocks that should benefit from an accommodating Federal Reserve and improving trade picture. This includes financials, industrials, technology and pharmaceuticals.
Our optimistic view on stocks for 2020 rests on the following:
- The Federal Reserve will leave interest rates unchanged or even cut in the 1st quarter.
- Relief will follow the Senate’s acquittal of President Trump.
- Corporate earnings will continue to impress.
- The “trade war” with China will temporarily cool, supporting higher stock prices.
While our view for 2020 is positive for stocks, we expect weakness to creep into the stock market as we enter 2021. This weakness should be short-lived and resemble more of a “garden-variety” selloff rather than anything more dramatic.
As we progress through 2020, we will share our perspective on what may lead to a recession in 2021. Until then, we see an environment that remains compelling for owning stocks.
Craig Kessler, Chief Investment Officer
Kessler Investment Group, LLC