S&P 500 hits record high as Fed hints at possible rate cuts

Value stocks are about as exciting as watching grass grow, but have you ever noticed just how much  your grass grows in a week?- Christopher Browne, was former manager of mutual fund company Tweedy Browne and legendary value investor

The month of May seems like a distant memory now after the S&P 500 Index closed at a record high on Thursday and ended the week with a gain of over 2%. Stocks fell about 6% in May but have come roaring back this month as interest rates have declined and optimism has returned over a possible trade deal with China. The Dow Jones Industrial Average and the Nasdaq Composite Index were also strong last week, although both averages fell short of posting new highs of their own. The catalyst for the rally in stock prices came from the Federal Open Market Committee meeting as the Fed hinted at a possible rate cut as early as the next meeting in July. The Federal Reserve kept interest rates unchanged at 2.25% to 2.50% and acknowledged that inflation is running below its 2% target and the economic outlook has become uncertain due to tariffs and trade tensions with China. In its statement, the Fed dropped the word “patient” to describe its approach to monetary policy and did not rule out a rate cut. The current economic expansion is entering its eleventh year and Fed Chairman Jerome Powell said in his press conference that the goal of interest rate policy is to sustain the expansion. European Central Bank (ECB) President Mario Draghi also suggested that more stimulative measures are needed in Europe to jump start an economy that has stalled in recent months. Investors cheered the prospects for lower interest rates both in the U.S. and Europe as lower rates generally mean higher valuations for equities. Investors were also encouraged by news that President Trump will be meeting with Chinese President Xi Jinping at the upcoming G-20 summit meeting scheduled for June 28^th and 29^th. While it was confirmed that it plans to be an extended meeting, we’ve been down this road before as optimism was high during past trade negotiations only to see talks fall apart with no trade agreement reached. The most important takeaway this past week from the strong stock market action is the power and influence that the Federal Reserve wields through monetary policy that affects not only the economy but stock prices as well.

Last Week

Leading economic indicators in May were flat, suggesting slower growth in the months ahead as fewer jobs were created last month and U.S. trade talks with China collapsed with no agreement. Existing home sales rose modestly in May and the flash manufacturing and services purchasing manager’s indices (PMI) fell slightly in June.

The price of oil rose and ended the week at nearly $58 a barrel as tensions between the U.S. and Iran escalated.

For the week, the Dow Jones Industrial Average rose 2.4% to close at 26,719 and the S&P 500 Index added 2.2% to close at 2,950. The Nasdaq Composite Index jumped 3% to close at 8,031.

This Week

The third and final estimate of first quarter gross domestic product (GDP) is expected to be 3.1%, the same as the previous estimate. May durable goods orders are forecast to increase slightly after dropping in April and the ISM Chicago Purchasing Manager’s Index (PMI) for June is forecast to be solidly in expansion territory with a slight increase from May.

The Federal Reserve’s preferred inflation gauge, the personal consumption expenditures (PCE) index, is expected to remain unchanged from April’s level of a 1.6% year-over-year rise. The Consumer Confidence Index for June should remain at near record highs.

Among the most notable companies scheduled to report quarterly earnings this week are KB Homes, Lennar, Micron Technology, Accenture, General Mills, Constellation Brands, ConAgra Brands, FedEx, Nike and Walgreen Boots Alliance.

Portfolio Strategy

Just when you thought interest rates could not go any lower, global central banks around the world seem poised to reduce the cost of borrowing to stimulate their economies. It was only about six months ago that the Federal Reserve had said that interest rates were a long way from neutral, implying that the Fed would begin to raise interest rates in order to normalize monetary policy. But with economies worldwide slowing and inflation under control, central banks are considering loosening monetary policy even further to reignite global growth. In the U.S., lack of inflation and the prospect of slowing growth have caused bond yields to plunge, with the 2-year Treasury yielding 1.77% and the 10-year Treasury yielding 2.07%. The current federal funds rate is between 2.25% and 2.50% and it looks like those rates are headed lower in the foreseeable future. Interest rates overseas are even lower. The European Central Bank (ECB) has a benchmark interest rate of negative 0.4% and the Bank of Japan (BOJ) has a rate of negative 0.1%, which some predict could fall to minus 0.3% by year-end. ECB President Mario Draghi is on record saying that more stimulus is needed to spur growth in Europe and reducing interest rates even further is certainly a possibility.  Provided economies are healthy and are growing modestly, lower interest rates are a boon for those investors willing to take on additional risk. In this type of environment, growth stocks should perform well. For fixed income investors, low interest rates make it difficult to generate income and investors would be wise to stick with quality and avoid longer-term issues as the yield curve remains relatively flat.