2nd Half Preview: Rates and Brexit

On December 24, 2018, the Dow Jones sat at 21,792… down 19% from a high of 26,951 made on October 3, 2018. General consensus was that the economy was slowing down and that the Federal Reserve would cause a recession in the near future from interest rate increases. Investor confidence was shaken.

Fast forward six months.

On June 24, 2019, the Dow Jones was back to 26,806… only half-a-percent below an all-time high, and the Federal Reserve appears to have signaled an end to interest rate increases. Surprisingly, Trump’s trade rhetoric with China and Mexico have failed to spook investors. A possible Middle East skirmish with Iran is also being ignored.

What about the next 6 months? There are two potential key themes for the remainder of 2019: interest rates and Brexit.

What will the Federal Reserve do with interest rates?

Almost everyone expects (and wants) an interest rate cut from the Feds this summer; perhaps no one more than President Trump, who continues to pressure the chairman of the Fed to stimulate the economy (thus increasing the odds of re-election). In all likelihood, we will probably see at least one rate cut before year-end.

Is an interest rate cut really a good thing for stocks? It really depends on your time horizon. The last three times that the Federal Reserve began cutting interest rates occurred in July of 1995, in January of 2001, and in September of 2007. In each instance, stocks rallied 3-5% following the announcement of a rate cut. In 1995, the rally continued for another 4+ years as stock valuations reached epic proportions, fueled by euphoria over internet stocks. Could the 1995 scenario happen again? Sure, another epic bubble is possible, but not likely, and certainly not a desirable outcome.

On the other hand, investors would have been wise to start selling equity positions after the two most recent rates cuts in January, 2001, and in September, 2007. In each instance, the Dow Jones Industrial Average fell more than 30% over the following 12-18 months.

The old adage “don’t fight the Feds” is true. But an equally powerful truth that I’m officially coining is “the Fed generally doesn’t cut interest rates unless it fears something pretty nasty is coming.”

Remember Brexit?

Click here for a refresher on the main points we discussed in our April 2019 blog post.

On April 11, the European Union leaders granted a six-month extension to the United Kingdom to work out the details on Brexit. The new deadline is October 31… Halloween. Honestly, could it be any more dramatic? Since that time, UK Prime Minister Theresa May has announced her resignation, and a new election is scheduled to be held in July.

The front runner to replace Theresa May at the moment is Boris Johnson. Johnson was a journalist in the 1980s before being fired for fabricating a quote in a prominent article. Johnson was also forced to resign from his next position as party vice-chair for the Conservative party, after lying about an affair.

His less-than-stellar reputation has drawn some classic quotes from those who know him well. The following quotes were taken from an article in the British publication, The Guardian, titled “A Question of Character? Boris Johnson By Those Who Know Him.”

“Boris, well, he’s the life and soul of the party but he’s not the man you want driving you home at the end of the evening,” said Cabinet minister Amber Rudd, speaking during a 2016 debate before the Brexit referendum.

“The Johnsonian creed [is] that it is, in his own words, acceptable, sometimes desirable to lie. Certainly, that approach has been advantageous to him. But it must come at a price.” wrote Sonia Purnell, Johnson’s biographer, after he withdrew from the leadership race in 2016.

“The worst foreign secretary we’ve ever had... disinterested and out of his depth, he cared nothing for our situation. Good riddance.” quipped John McKendrick, attorney general of Anguilla, bidding farewell to Johnson as foreign secretary in 2017.

More concerning for the direction of equities, Johnson has been vocal about the fact that he is prepared to break away from the European Union without a deal in place, which could spell chaos for markets.

The best-case scenario at this point is that Brexit will create little more than noise in the markets. The worst-case is that Brexit triggers a European slowdown and fuels large problems for the global economy.

The second half of 2019 could mark an important turning point for economic policy (interest rates) and geo-political drama (Brexit). Stocks aren’t cheap and the market appears to be pricing in an optimistic outcome to both scenarios. Unfortunately, that can be a recipe for disappointment.

Any opinions are those of Brady Raanes and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete.

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