US equity markets in a Catch-22

The final FOMC meeting of 2018 takes place this week with investors looking for visibility into what monetary policy will look like in coming quarters. Perversely, equity markets are in a catch-22. Update Yahoo Finance Fed hikes rates, but signals just two more hikes in 2019.

Recent speeches by Fed Chair Powell and other leading figures of the Federal Reserve have indicated that the Fed will likely ease the pace of any additional tightening in coming quarters. Given that rising interest rates have been a major headwind for equity markets in the second half of 2018, you might think that a shift towards a less hawkish Fed would potentially re-ignite a rally in US equity markets. However, given the risk-adverse nature of trading in recent months, it is more likely that investors will interpret a more dovish policy stance as confirmation that the US economy is slowing – effectively triggering additional loses in the near term for US equity market investors. If, on the other hand, the Fed remains vigilant, in terms of forecasting additional tightening, US equity markets will remain under pressure in anticipation that any additional tightening will certainly trigger a meaningful slowdown in the second half of 2019.

In addition to that monetary policy catch-22, investors are also increasingly shifting their focus to a theme that could potentially add momentum to any trade lower – a weakening profit outlook for US companies.

As I have often underscored, US equity markets remain largely tethered to two metrics of measure for trend, other than interest rates: economic data and corporate earnings.

Using the S&P 500 as a proxy for the broader market, analysts have trimmed S&P 500 EPS by 2.5% over the past two months. That reduction of S&P 500 EPS forecasts is the largest in 18 months. Clearly, a 2.5% reduction in forecasts is not disruptive in and of itself. However, when paired with recent volatility, risk-off trading, and concern over monetary policy, it does take on a significantly larger profile and meaning for investors as we look to close out 2018.

Given the headwinds investors now face, as outlined above and in recent notes, and the technical damage that has been inflicted on markets over the past four months, the most optimistic one can be for the near term is that we see the Nasdaq remain above 6900. A break below that level could well beget additional weakness.

This week’s economic calendar will be dominated by the Fed. The FOMC meeting begins on Tuesday, and ends with the FOMC announcement on Wednesday at 2:00 pm. It is then followed by FOMC forecasts and Jerome Powell’s press conference. The street is still expecting the FOMC to raise rates on Wednesday by 25 bps. However, the odds of a March move on rates is now slightly below 50%. That will likely shift once the FOMC releases its dot plot this week. Currently, the street is expecting 3-2 move in 2019.

Housing starts on Tuesday and existing home sales on Wednesday are unlikely to be market moving – though important. Weekly jobless claims remain depressed – suggesting continued strength in employment. On Friday November’s Durable Goods Orders are released. They are expected to swing back to positive (+1.5%) from October’s sobering -4.4%. Also on Friday, the final Q3 GDP figures will be released. Econoday consensus is calling for 3.5% – unchanged from the last reading.

Chart: Yahoo Finance The Final Round Dec. 19, 2018 

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