Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble…to give way to hope, fear and greed. – Benjamin Graham
Trade negotiations between the U.S. and China resumed last week and when the talks ended on Friday, investors were finally rewarded with some good news, although it was not the broad deal they had been hoping for. After plunging early in the week on fading optimism that a deal would be reached, the major stock averages rallied to close modestly higher by Friday’s close. Nothing else seemed to matter last week as the focus was squarely on trade. Investors had lowered their expectations when Chinese trade officials said they were not in favor of a broad trade deal. The U.S. countered by saying it would be open to a short-term deal with a plan to address structural issues at a later date. Prior to the actual negotiations, the U.S. also added some of China’s top artificial intelligence firms to its blacklist in retaliation for China’s treatment of Muslim ethnic minorities. While this move was not directly trade-related, it did add to the skepticism that any trade agreement would be reached. When China commented that it would be open to a partial trade deal as long as no additional new tariffs were imposed, sentiment among investors became more positive. After meeting with Chinese Vice Premier Liu He on Friday, President Trump declared that the two sides had reached an agreement on “phase one” of a deal. China agreed to purchase between $40 and $50 billion in U.S. agricultural products and, in return, the U.S. agreed to postpone increasing tariffs on $250 billion worth of Chinese imports set to take effect on October 15th. Both sides also agreed to begin “phase two” talks immediately, but there was no clarity as to what these talks would involve. While this was certainly not the comprehensive trade agreement that many had hoped for, it was better than nothing and left investors satisfied that some progress had been made and optimistic that further talks would produce more positive results. Time will tell whether or not the markets are as sanguine.
Both the producer price index (PPI) and the consumer price index (CPI) in September were weaker than expected as inflation remained benign. The PPI posted its largest decline since January and in the 12 months through September, it has increased only 1.4%. The CPI was unchanged, which was also its weakest reading since January, and has increased just 1.7% through September. The University of Michigan consumer sentiment index was better than expected in October.
Minutes from the Federal Reserve meeting in September showed that the trade war was the main concern for Fed officials. They also were concerned that markets were expecting more interest rate cuts than the central bank was willing to deliver. The markets are betting on another rate cut in October because of slowing global growth, the negative effects of the trade war and inflation hovering below 2%.
For the week, the Dow Jones Industrial Average rose 0.9% to close at 26,816 and the S&P 500 Index added 0.6% to close at 2,970. The Nasdaq Composite Index gained 0.9% to close at 8,057.
Retail sales for September are expected to post a modest increase in line with the previous month while September industrial production is expected to fall slightly after a healthy increase in August.
Third quarter earnings season begins with a slew of profit reports, particularly from the financials. Among the most notable of these are Citigroup, JP Morgan Chase, Wells Fargo, Bank of America, U.S. Bancorp, Goldman Sachs, Morgan Stanley, Charles Schwab, Blackrock, American Express, UnitedHealth, Johnson & Johnson, Abbott Labs, IBM, Honeywell and Union Pacific.
Although yields on bonds have declined sharply this year and have resulted in above-average total returns for fixed income investors (bond prices move inversely to yields), it’s a struggle for investors to find attractive yields in this low interest-rate environment. To make matters worse, there is a 75% chance that the Federal Reserve will cut interest rates again when it meets later this month. The fact that there is over $15 trillion in negative-yielding debt throughout the world only adds to the problem and makes U.S. debt more attractive by comparison. Treasury yields with maturities of 10 years or less are below 2% while investment grade corporate bond yields are only in the 3% to 4% range depending on the credit quality of the issuer and the maturity structure. For those investors in a high tax bracket, high-grade municipal bonds only offer yields between 1% and 3%. Money market fund yields are also below 2% and are likely to fall even further if the Federal Reserve continues to reduce the federal funds rate. With inflation running below 2%, the real return on bonds and money market funds with these low yields is paltry. When federal and state taxes are taken into account, the returns shrink even more. For investors with a diversified portfolio of stocks, bonds, alternative investments and cash, bonds and money market funds provide a ballast in the event stocks sell off and provide negative returns. Because the yield curve is flat right now with little difference between short-term bond yields and longer-term bond yields, it makes sense for investors to stay relatively short since they are not properly compensated for the risk involved in extending maturities should interest rates suddenly move higher.