The Fed ‘put’ could insulate stocks from trade war, send Dow to 28,000

Traders work on the floor at the New York Stock Exchange.

Brendan McDermid | Reuters

With a potentially negative earnings season looming, investors see easy Fed policy as the security blanket the stock market needs as it breaks to new highs.

The thinking is that there is a “Fed put” on the stock market, meaning with the Fed ready to cut interest rates, how much downside could there be for the market? But that question gets trickier with the stock market carving out new highs, and an upcoming earnings season that is forecast to see profits decline.

The Fed “is the factor,” said Michael Farr of Farr, Miller & Washington. “If you don’t have organic earnings growth and improving balance sheets, what else is going to drive prices?”

Fed Chair Jerome Powell’s dovish comments this week sparked a stock market rally Wednesday and part of Thursday, driving the three major indices to new highs. Stocks were off their highs Thursday afternoon, after indices briefly breached big round milestones. The S&P 500 rose above 3,000 for the first time ever Wednesday, and the Dow topped 27,000 Thursday. Many Wall Street analysts have their year end targets set around 3,000 or below, and the average target of analysts surveyed by CNBC is 2,950.

Economists widely expect the Fed to cut interest rates at its July meeting by at least 25 basis points, or a quarter point. The fed funds target rate range is currently 2.25% to 2.50%. Investors in the fed fund futures market are pricing in a little more than a full quarter-point cut for July, but nearly three cuts of that amount by the end of the year.

“My thought is if rates don’t fall, stock prices will,” said Sam Stovall, chief investment strategist at CFRA. If the Fed does not take action to cut interest rates at at its next meeting, on July 31, Stovall said the market could head for a correction pretty quickly.

Stocks have been rising ahead of the Fed’s expected action, and history shows they could keep on rising once the Fed starts the rate-cutting cycle. Stovall said the S&P 500, since World War II, has risen 10.3% on average in the six months after the Fed starts cutting rates, and then 14% by the end of the first year.

Beyond the Fed, strategists said the stock market needs to see steady economic data and the trade war to be resolved between the U.S. and China to make a big leap forward.

“I think the market is trying to decipher now how many rate cuts and how much and whether the first one will be an important inoculation. Clearly the Fed sees the global slowdown coupled with uncertainty with the tariffs as a significant downside risk,” said Quincy Krosby, chief market strategist at Prudential Financial.

Net benefits to stocks from lower interest rates could be a weaker dollar, which would filter through as a positive to the earnings of S&P 500 companies with overseas sales. Highly indebted companies, including many smaller firms, would also see a lift from lower interest rates.

“If the Fed is here and the tariff issues are resolved, the markets can continue moving higher. There is no doubt there will be pullbacks. But nonetheless, the Fed will help…It will weaken the dollar. It will be helpful for all markets. It will be helpful for emerging markets. It will be helpful for the Chinese. And U.S. exporters,” said Krosby. “Right now for the market, if they’re going to lower rates and there’s no further deterioration in the economy, that is the best back drop for markets.”

But the rollout of corporate earnings next week could be a challenge.

Stovall said S&P 500 earnings are collectively expected to decline 1.7% for the second quarter, after rising 2.5% in the first quarter. Earnings are key to the way the market values stocks, and with the earnings season starting next week, bad news could come out not only in the second quarter reports but in forecasts. Companies could certainly be glum as they detail the impact of tariffs, global weakness and even dollar strength on their bottom lines.

Rate-cutting cycles and stocks

Industrial supply company, Fastenal, for instance, reported Thursday that it was able to raise prices to offset tariffs on products sourced from China, but the increases were not enough to offset rising costs.

But analysts expect that, like last quarter, companies have guided too low on their profit outlooks, and earnings may surprise to the upside.

“On the whole, given the fact that earnings expectations are so subdued, it’s not likely to be an aggregate market negative,” said Julian Emanuel, chief equity and derivative strategist at BTIG. “It’s going to be an environment, where it’s good for some stocks, bad for others.” On top of that, the Fed’s rate cutting can only help a market that has already run up ahead of the Fed’s action.

Emanuel said cyclical parts of the market could benefit more from lower interest rates, including energy and financials.

The Fed had been criticized for its last rate hike in December, when stocks sold off, the outlook for growth began to fade and trade wars weighed on business confidence. But the Fed paused its rate hikes early in the year, and began in earnest to make the shift toward an easier policy when trade friction between the U.S. and China heated up in May.

Big moves have already been seen in the real rates market. Treasury yields, which move opposite bond prices, have dropped dramatically. The benchmark 10-year Treasury yield went from a 2019 high of 2.799% to a low of 1.93%. It was at 2.12% Thursday. That yield influences mortgages and other lending rates.

Just the recent rise in long-term rates shows that the market believes the Fed will succeed in fending off a recession, Emanuel said.

“If you look at the entire year, the fact that the Fed pivoted as it did on Jan. 4, to be on balance supportive of the market, it’s very important,” said Emanuel. “And it’s all the more important given the developing expectation there is no quick fix for the trade war and the whole idea that earnings growth is subdued.”

What about global economy?

Emanuel said for the market to see significant gains, investors will have to embrace the idea that global economic weakness will not drag down the U.S. “For their to be material upside, those cyclical stocks need to lead…People have to come to grips with the concept that there isn’t going to be a recession, whether the Fed engineers no recession or a trade deal engineers no recession…or just the fact you’re in the year before an election means no recession.”

Stovall said the Fed’s rate-cutting cycles have not all signaled recession, as some fear.

“In the mid ’80s, we did not have a recession. In the mid ’90s, we did not have a recession. In the late ’90s, we did not have recession,” he said, noting there were seven rate-cutting periods altogether since 1980, three without recession.

“This could be like 1995 all over again, in which the S&P rose 34% that calendar year. The Fed stopped raising rates in early February, and started cutting rates in early July. What’s very interesting of that 34% for all of 1995, two-thirds of it occurred before the rate cut even happened,” said Stovall. This year, the S&P is up more than 19% so far, and the Dow is up about 16%.

The Fed’s anticipated rate cut is unusual in that it comes at a time of very low unemployment and an economy that is growing at trend of about 2%. The economy added a surprisingly strong 224,000 jobs in June, and there was an unexpected pickup in consumer inflation, with core CPI rising at a 2.1% pace year over year, one of the highest readings during the recovery.

Powell told Congress this week that the Fed could act to keep the recovery going because it’s concerned about global economic weakness and the impact of the trade war on the economy. He also said that inflation has remained stubbornly low.

“I’ve now come to the conclusion the Fed is going to to cut rates not because of the weakness in the U.S. economy but because they want to make the coordinated effort to forestall a global recession,” said Stovall. “We are like mountain climbers all tethered together. The U.S. might be the lead climber, with a firm grip and solid footing but if all the other climbers fall, they’re going to drag us down with them.”

But there is a risk from too easy central bank policy, and some investors are worried about the Fed creating a bubble.

Nomura strategists say there’s a risk for a stock market that has run up, with the easy hands of the Fed on the tiller. The market may not be satisfied after the July cut and could demand even more Fed easing.

In a note, the strategists said they expect the risk-on mood will continue in U.S. stocks through the Fed meeting. But hedge funds, and trend following investors who might like buying stocks in July, a typically low-volatility period, may have a different view in August, which is often when seasonal volatility kicks up.

“Summertime anxiety has the potential to result in a market that clamors even more loudly for the exercise of the ‘Fed put,'” they wrote.

WATCH: Powell says relationship between inflation and unemployment is gone

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