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S&P 500 sheds 2% on interest rate fears, tariffs

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. – Warren Buffett

Although the S&P 500 posted gains on Monday and Friday of last week, they weren’t sizable enough to overcome the losses suffered in the middle of the week and the benchmark index fell 2%. The Dow Jones Industrial Average posted even larger losses while the technology-laden Nasdaq Composite Index lost about half that amount. It was an ugly February as the S&P 500 snapped its 10-month winning streak with a loss of 3.9%. Probably the biggest reason for the stock market’s weakness last week was increased uncertainty over Federal Reserve monetary policy and the outlook for interest rates. In new Fed Chair Jerome Powell’s testimony before Congress, he indicated that the Fed could hike rates more than three times this year if economic and inflation data continue to improve. While it’s a foregone conclusion that the Fed will raise the federal funds rate by 25 basis points at its March meeting, Fed officials will also be making new projections about future rate hikes. They could be influenced by the recently enacted tax cuts as well as the new $400 billion government budget deal and the possibility of a massive infrastructure spending bill. Even though there are no signs of wage inflation yet and no evidence of the economy overheating, Powell expects the Fed to continue raising rates gradually to stay ahead of the curve. It doesn’t want to see inflation spike and be forced to raise interest rates rapidly, causing the economy to fall into a recession. The stock market was also caught off guard last week by President Trump’s announcement that the U.S. would slap a 25% tariff on steel imports and a 10% tariff on aluminum imports as a way to protect both industries. Tariffs are essentially a tax on goods and could lead to higher prices on products that use steel and aluminum and increased inflation. They also could lead to a loss of jobs and spark a trade war with other countries intent on retaliating with their own tariffs. How this eventually plays out is uncertain and one thing the stock market does not like is uncertainty.

Last Week

Economic data took a back seat last week to Jerome Powell’s testimony and Trump’s tariff announcement. U.S. fourth quarter GDP was revised lower to 2.5% from 2.6% and durable goods orders in January fell more than expected due to a sharp drop in commercial aircraft orders. That coupled with weak January retail sales, industrial production and home sales data could be an indication that economic growth is moderating in the first quarter. New home sales fell in January for the second straight month and pending home sales also fell, hitting their lowest point in nearly four years due to a low supply of homes for sale. On a positive note, the ISM manufacturing index was better than expected and hit its highest level in 13 years while both the February consumer confidence index and Michigan consumer sentiment index were near their recent highs. Weekly jobless claims fell to their lowest level since December 1969.

For the week, the Dow Jones Industrial Average plunged 3% to close at 24,538 while the S&P 500 Index lost 2% to close at 2,691. The Nasdaq Composite Index fell 1.1% to close at 7,257.

This Week

The February employment report will be released on Friday and it is expected that 195,000 jobs were created and that the unemployment rate declined to 4.0%. The February ISM non-manufacturing index is forecast to fall slightly but remain strong and January factory orders are expected to drop after posting an increase in December.

The European Central Bank (ECB) meets and is expected to leave interest rates unchanged.

Among the most prominent companies scheduled to report earnings this week are Target, Costco Wholesale, Kroger, Dollar Tree, American Eagle Outfitters, Autodesk, Verifone Systems and H&R Block.

Portfolio Strategy

The February employment report to be released on Friday could take on added significance after last month’s report showed that average hourly earnings rose 2.9%, igniting inflation and interest rate fears, spiking volatility and sending stocks lower. Although the Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) index, rose more than expected in January, it has risen only 1.7% in the 12 months through January, less than the Fed’s 2% targeted rate. It is possible that the labor market could continue to strengthen without causing inflation. What seems to have been forgotten in the market’s obsession with Federal Reserve monetary policy and inflation fears is the strength of the fourth quarter earnings season. Companies in the S&P 500 have reported revenue growth of 8% and earnings growth of 15% and none of these results have included the benefits of tax reform, which was passed at the end of December. More than three quarters of these companies have beaten revenue and earnings estimates and many of them are bullish for the rest of the year. They have increased their earnings guidance for the year and are generally upbeat about their prospects, thanks largely to the cut in the corporate tax rate from 35% to 21%. These potential savings could be spent on capital expenditures to generate future growth, increased dividends or stock buybacks, all of which should benefit shareholders over the long run.