Stocks have generally drifted lower this week after two strong weeks of gains that challenged old highs.

Bond yields have also traded within a narrow range. The Federal Reserve cut interest rates by 25 basis points, as expected, and suggested that future cuts would be dependent on economic data.

While expressing concerns about global weakness, the Fed seems to have developed a consensus that no recession is near at hand, but cuts are a legitimate consequence of a need to protect a slow growing economy from being infected by weaknesses caused by global deceleration and higher tariffs. At the same time, the Fed majority doesn’t appear to be in the mood to be very aggressive in its rate cutting posture. The whole world, in fact, seems to be ready finally to reconsider the notion that negative interest rates are a growth stimulant. Growth in both Europe and Japan hover near zero even as their respective central banks pursue a policy of negative rates and quantitative easing. While negative rates certainly penalize holding cash, they don’t necessarily force the holders to spend it. Rather, they react by taking more risks and invest in other financial assets that offer positive returns. In the short run, that might be great for stock and bond values, but once the lid is put back on the cookie jar and rates normalize, then what?

The answer is complicated. First, central bankers in those geographies living with negative rates are fearful reversing course will lead to recession or worse. Said a different way, they simply don’t have any idea how to exit bad policy without doing great damage. The scary answer is that quite possibly, there isn’t an easy way out. Buying all the bonds in sight as a way of pumping more money into the system creates chaos. More and more cash is looking for a place to park, but the amount of high-quality debt not already sopped up by central banks keeps shrinking. More demand and less supply mean higher prices. In the bond world, that means lower interest rates. With rates already negative, lower rates means the negative rates go even deeper into the red.

In our country, the chaos has begun to appear in the repo market, the prime market that supports overnight lending. Without getting deep into the weeds, the reduction of the Fed’s balance sheet has led to less cash and more collateral in the system. If too many banks at once need more cash to settle transactions in the normal course of business, there is a mismatch of too much collateral and too little cash. That causes temporary spikes in overnight lending rates. In turn, that has forced the New York Fed, which handles daily transactions, to infuse more cash into the system. This isn’t a systemic problem that should worry anyone at the moment, but it does point out that steps to effectuate monetary policy require adequate liquidity. When the Fed wants to hold rates relatively stable at the same time the Treasury needs to sell over $1.25 trillion in new debt every year to fund deficits, these clashes occur and they will occur more often unless other sources of cash (e.g. foreign buyers) emerge.

As for the markets near term, there is little news expected for the balance of this month. Low level trade talks between China and the U.S. are ending today, and it would be logical to expect a tweet that all is going well. The Chinese may even visit some farmers and promise to buy more soybeans. While markets expect some sort of agreement before Christmas, it isn’t likely to be substantive enough to move markets materially higher. Yes, the suspension of the next planned round of tariffs in December would be a pleasant outcome, but the recent rally has largely discounted that. Any reduction of tariffs already in place, matched with Chinese promises to be more respectful of intellectual property, could be a propellant, but it is too early to go that far. Nothing this week will lead anyone to that conclusion.

Economic data has generally been good. The most pleasant surprise was the increase in industrial production in August. Markets will await September data, which is still 10 days or more away. There may be a smattering of earnings news over the next week, including a few preannouncements from companies that are doing much better or worse than expected. But, for the most part, earnings news is 3-4 weeks away.

Thus, we don’t expect a major move in either direction until rates change materially or there is a real adjustment to earnings expectations. Stocks are flirting with recent highs, but the gains since the January 2018 peak have been small. Flat earnings for three quarters have resulted in slightly lower expectations offset by lower rates. Unless recession indicators flash yellow or red soon, it is logical that the path of least resistance for rates is higher. That means earnings expectations need to rise for stocks to move solidly higher. Q4 is often a good time for stocks. I think management commentary that will accompany Q3 earnings will be relatively cautious given the announced intent to increase tariffs in December. But if those tariffs don’t happen, there could be a move to new highs. That won’t happen until there is more clarity on tariffs and that isn’t something we are likely to hear this week or next.

Today, Sophia Loren is 85.

James M. Meyer, CFA 610-260-2220

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