Stocks rebound strongly despite geopolitical headwinds

In trading you have to be defensive and aggressive at the same time. If you are not aggressive, you are not going to make money, and if you are not defensive, you are not going to keep money. – Ray Dalio, American investor and hedge fund manager

Stocks resumed their upward climb last week after turning in their worst performance of the year the previous week, although reasons for the strong showing are unclear. The S&P 500 Index and the Nasdaq Composite Index posted gains of nearly 3% and 4%, respectively, but the Dow Jones Industrial Average was up only about 1.5% as shares of Boeing weighed on the index. After an Ethiopian Airlines 737 Max 8 jet crashed last Sunday, Boeing’s stock fell hard and remained under pressure all week. The stock reached its low midweek when the U.S. and Canada followed a host of other countries in grounding all Boeing Max 8 jets. By Friday, shares of Boeing began to recover as the company announced plans to implement a software upgrade that presumably would solve the problem. There wasn’t any good news on the geopolitical front, either, as Prime Minister Theresa May’s Brexit deal suffered a second defeat in Parliament. With the deadline only two weeks away, it was hoped that European Union members would allow Britain more time to reach a deal. There also were reports that more progress was being made on U.S.-China trade talks, but a meeting between Chinese President Xi Jinping and President Trump was postponed until at least April, kicking the can further down the road and leaving investors uncertain as to whether a trade agreement would ever be reached. China’s economy, which is the second largest in the world, is slowing and the country will likely maintain strong stimulus measures, such as lowering interest rates and cutting taxes for consumers and businesses to stem the tide of slower growth. Earnings and economic data again took a back seat to geopolitical events, but inflation data last week was benign, enabling the Federal Reserve to be patient in raising interest rates. Without the fear of the Fed tightening its monetary policy and normalizing interest rates and with bond yields low, investors are more comfortable owning risk assets such as stocks.

Last Week

Inflation data released last week confirmed that prices remain under control. The consumer price index (CPI) and the producer price index (PPI) in February were only slightly higher. Over the past year, the CPI has increased 1.5% while the PPI has risen 1.9%, both below the Fed’s 2% target rate of inflation. February import prices were higher due almost entirely to higher fuel prices but with fuel prices excluded, import prices were flat and have actually fallen in the past 12 months. Durable goods orders in January were much better than forecast and core capital goods orders, a reliable measure of business investment, posted the largest increase in 6 months. U.S. construction spending was also strong in January and the preliminary University of Michigan consumer sentiment index in March exceeded expectations.

For the week, the Dow Jones Industrial Average rose 1.6% to close at 25,848 and the S&P 500 Index jumped 2.9% to close at 2,822. The Nasdaq Composite Index soared 3.8% to close at 7,688.

This Week

After last week’s plethora of economic data, this week’s calendar will seem light by comparison. January factory orders are expected to increase over those reported in December and be better than expected while February existing home sales should exceed the number released in January. February leading economic indicators are forecast to edge slightly higher.

The Federal Open Market Committee (FOMC) meets this week and is widely expected to keep interest rates unchanged.

Among the most prominent companies scheduled to report fourth quarter earnings this week are FedEx, General Mills, Nike, Darden Restaurants, ConAgra Brands, Tiffany, Carnival, Cintas and Micron Technology.

Portfolio Strategy

Both the stock market and the bond market have been strong lately and this positive correlation is somewhat unusual. Rising stock prices are normally associated with a vibrant economy characterized by strong growth, higher inflation and steadily increasing corporate earnings. On the other hand, higher bond prices (coupled with lower bond yields) are consistent with weakening economic growth, subdued inflation and declining earnings. After posting a negative total return last year, the S&P 500 Index has come roaring back and is up over 13% through the close of business on Friday.  At the same time, bond yields have trended downward as the yield on the 10-year Treasury has fallen to 2.59%, the lowest level since January 2018. The yield on the 2-year Treasury has also dropped to 2.43%, indicative of a relatively flat yield curve where the difference in yields is a paltry 16 basis points. (A basis point is one hundredth of a percent). While this relationship between the two yields is worrisome, it won’t be a real cause for concern until the yield curve actually inverts (with the 2-year Treasury yield higher than the 10-year Treasury yield). More often than not, a recession ensues when this occurs. Time will tell whether the stock market or the bond market is accurately forecasting the future direction and strength of the economy and corporate profit growth. In the meantime, the fear of missing out on possible future gains in equities is causing investors to pile into stocks.