Joe Zidle: The Case Against a Melt-up

By Joe Zidle June 21, 2019

With tariffs against Mexico suspended and Fed cuts fully priced in, risk assets are pushing up against their April highs. However, a sustained melt-up—higher highs in equities and tighter spreads in credit—is unlikely in the short term. This is the market playing the part of Goldilocks, and we don’t think that conditions are “just right” for any more significant gains this year.

The Fed could disappoint The market seems to be getting ahead of itself when it comes to rate cuts. Before tariffs on Mexico became an issue, the market priced in one interest rate cut this year; once they did, expectations jumped to three cuts. The threat is gone, for now, but the market’s optimism remains. Fed fund futures suggest the Fed will cut three times this year, beginning as early as next month. The US doesn’t have a growth problem, and Core CPI weakening from 2.1% in April to 2.0% in May hardly seems like a reason for central bankers to panic.⁽¹⁾ It’s unclear if a “Fed put” exists when the S&P 500® is up 16% YTD,⁽²⁾ but we would take the other side of that bet.

Little clarity on trade Sometime in the next 45 days Mexico must show “substantial” progress on curbing the flow of drugs and illegal immigration. Only President Trump knows what will be accepted as progress; the rest of us are left only to guess. Meanwhile, China retaliated with measures beyond trade, targeting US companies in China and taking steps to reduce Chinese tourism to the US. President Trump also signaled his intentions to target European autos and, apparently, wine. We aren’t panicking yet—after all, California and Oregon produce some epic grapes, The North Fork is improving and New Jersey’s are serviceable.

Earnings are still a problem Corporate profits aren’t receiving enough attention. By some estimates, in 1Q’19 S&P 500 profits fell on a year-over-year basis for the first time since early 2016. Earnings growth expectations for 2019 were already low at 2–5% after profits grew faster than 20% last year. But leading profit growth indicators continue to deteriorate, suggesting that an earnings recession is a risk and that earnings forecasts may need to be revised down. The chart below highlights the relationship between manufacturing production and US corporate profits.

 

Too late to go to sleep, too early to get up Expectations that the Fed will deliver 75bp worth of cuts and that trade will resolve itself should be challenged. Economic growth is near-trend, inflation is a touch weak and trade partners are gearing up for a sustained conflict. Investors should prepare for downside in equities and less than coupon-like returns in fixed income, as markets are unlikely to mount a sustainable rally from here. We aren’t bearish. This isn’t the end of the cycle, but rather a late-cycle pause. It’s more like waking up at 3:00 am—too late (for some) to go back to sleep but too early to get up. Instead, we must walk carefully in the dark.

 

 

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Footnotes:
1. Source: Bureau of Labor Statistics, as of 5/31/19. Core CPI represented by the Consumer Price Index for All Urban Consumers: All items less food and energy, seasonally adjusted (1982-84=100).
2. Source: Bloomberg, as of 6/17/19. Represents total return with dividends reinvested.

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