Powell Paves The Way For A Year-End Rally

Stocks opened at their lows yesterday after China returned fire at the Trump administration overnight with sanctions on the US divisions of a South Korean ship builder. The sell-off did not last long, as third-quarter earnings reports from several of our largest banks were much better than expected, lifting sentiment. The major market indexes fell back into negative territory in the final hour after President Trump threatened China with a cooking oil embargo in his latest form of retaliation. I see cooking oil as a pea shooter, whereas rare earths are a bazooka in this ongoing trade dispute. Ultimately, the Trump administration has to come to a new agreement with China that de-escalates trade tensions, which should be interpreted as bullish by the market.

The most important development from yesterday’s session came from Chairman Powell during a speech in Philadelphia. In my view, he insinuated that another rate cut was coming at the end of this month when he stated that “the downside risks to employment appear to have risen,” based on a “wide variety of public- and private-sector data that have remained available” after the government shutdown. While acknowledging that the rate of inflation remained elevated at 2.9%, this seemed like a lesser and more transitory concern given that it has been due to core goods price increases from tariffs. The two-year Treasury yield, which is a proxy for where the market sees the Fed’s short-term rate headed, fell to a three-year low of 3.47%.

The market now sees two more rate cuts coming at the end of this month and in December. In addition, Chairman Powell indicated that the Fed would soon stop shrinking its balance sheet, otherwise known as quantitative tightening, in a move to preserve liquidity. That would be another form of monetary stimulus in that it ends the ongoing tightening from balance sheet runoff. These are two more bullish developments in a monetary sense that should help sustain the economic expansion and propel risk asset prices to higher levels.

As a result, we should see further yield curve steepening, with the spread between the 2- and 10-year Treasury yields approaching their long-term average of 1%. I see the 10-year moving back to 4.5% in that process, as the 2-year bottoms in the 3-3.5% range near a neutral Fed funds rate. Bears suggest this yield curve steepening is bearish, as it was in 2000, 2007, and 2019, but those resulted from short-term rates rising. This steepening should come from the short-term rate falling, which is a critical distinction.

Earnings started off exceptionally strong with several of our largest banks reporting yesterday. According to FactSet, the expected earnings growth rate for the S&P 500 in the third quarter is 8%, but it is likely to be double digits once we have all the results. Earnings have exceeded estimates in 37 of the past 40 quarters, with the only exceptions being during the 2020 recession and in the second half of 2022. Over the past five years, earnings have exceeded estimates by an average of 8.4%. With fewer than 30 companies reporting so far, the beat percentage is already 3.8%, but it should rise in line with previous quarters.

We are on track for a fourth consecutive quarter of double-digit earnings growth, which explains why the S&P 500 has rebounded from its April low. That may validate where we are, but it will be guidance that determines where we are headed. On that front, the rate of economic growth is critical.

What I found notable about yesterday’s bank earnings reports is that most signs showed the consumer remains on a strong footing. Loan portfolios appear to be performing well, and credit quality is holding up with minimal changes to net charge-offs. Granted, these are higher-quality money center banks, but they account for the bulk of consumer spending. Disgruntled bears continue to focus on the weaker aspects of our economic engine, including a softening labor market, deterioration in credit for lower-income households, and a struggling housing market. I don’t dispute those headwinds, but economic data needs to be looked at in aggregate, and these smaller headwinds are more indicative of a mid-cycle slowdown in the economy rather than the end of the expansion. If investors want to be on the right side of the market, they need to make that distinction. Chairman Powell just paved the way for a soft landing next year with yesterday’s commentary, which tells me we have a fourth year ahead for this bull market. I look forward to buying the dips when they present themselves.