For the U.S. stock markets, the month of June was one for the record books. After falling 6.7% in May from the collapse of U.S.-China trade negotiations, the Dow Jones Industrial Average (DJIA) roared back in June, posting a 7.2% gain. It was the DJIA’s strongest June performance in 81 years. The S&P 500 rose 6.9% and the tech-heavy NASDAQ increased 7.4%, each posting their best June gains in 64 years and 19 years, respectively.
For now, the June surge has carried over into July. On Wednesday, the DJIA, S&P 500 and NASDAQ all closed at new all-time highs. But the stock market, and its investors, need to brace for their biggest obstacle to continued gains – the U.S. Federal Reserve.
Tasked by Congress to set U.S. monetary policy, the Fed manipulates interest rates to promote the growth and stability of our economy. As I mentioned in my June 16 article, “Facing criticism, Fed signals rate cuts”, the Fed has now expressed a willingness to start lowering interest rates. By lowering interest rates, the Fed reduces the cost of borrowing for consumers and businesses to buy goods and services on credit. This lower cost of debt inherently increases spending, thus stimulating further economic growth.
The Fed has stated it is willing to start lowering interest rates if it continues to see signs of strain in economic growth. But the Fed has not formally projected any rate cuts this year. In other words, there is no guarantee the Fed’s willingness will actually translate to lower interest rates. The markets, however, are expecting the Fed to cut interest rates two to three times in the next six months with a 97% chance the first rate cut will be at the Fed’s July 31 meeting. And it’s this disconnect between the markets and the Fed that can potentially halt the advance in stock prices. You see, much of the stock market’s gains in June were predicated on the Fed cutting interest rates.
For the markets, the Fed’s resolve to lower interest rates will be put to the test at its July 31 meeting since the U.S. Bureau of Economic Analysis will release the latest Gross Domestic Product (GDP) report on July 26. GDP is the total dollar value of goods and services produced by our nation and is the main indicator of economic growth.
The July GDP report will give the markets its first glimpse of economic growth for the April-June second quarter. The markets are expecting a pullback from the first quarter’s strong economic growth rate of 3.1%, but just how much of a pullback is the great unknown. Current estimates for second quarter economic growth range from 1.3-2.5%.
With the expected evidence of weaker economic growth, the Fed will be hard-pressed not to lower rates at its upcoming July meeting. Moreover, a lessened pace of growth would be against a backdrop of the U.S.-China trade dispute, itself a disrupting force to the economy. Yes, investors should celebrate the bounty of the June stock market surge and the 15% year-to-date gain in the DJIA. But this celebration needs to be tempered with a dose of caution.