Theresa May is in Brussels again, trying to sort out an extension for Brexit beyond the original March 29 date. Along with many other analysts, I thought this would be an easy task, but it is turning out to be more difficult than originally assumed. That unprecedented trouble, once again, raises the odds of a no-deal Brexit.
From the European leaders' perspective, why postpone Brexit unless May can get parliament to agree to a deal? How will extending the deadline help if parliament cannot agree on the deal to leave? Essentially, being willing to postpone Brexit beyond the deadline means European leaders would have to renegotiate their terms with May, which seems unlikely.
The British pound (GBP) fell against most major currencies today as investors absorbed the Brexit headlines. Investors sold U.K. stocks as well, even though the markets were initially cheered by an accommodative statement by the U.S. Fed on Wednesday.
In the following chart, I compared the GBP against the euro (EUR) in order to neutralize the impact of the dollar. When the EUR/GBP exchange rate is rising, it means the GBP is weakening against the EUR. That decline is a direct result of the uncertainty around Brexit. The exchange rate has completed a bullish stochastic divergence, which is a short-term signal, but it indicates a rising likelihood that the GBP will continue to weaken in the short-term.
Investors in U.S. stocks seemed to mostly brush off the Brexit news following the Fed's accommodative stance on Wednesday. The S&P 500 recovered from yesterday's losses and has completed a long-term inverse head and shoulders pattern. From a technical perspective, this is a positive sign that stocks will rally back to their prior highs established in September 2019.
The rally has had broad participation from most groups, except the big banks and brokers. As I mentioned in yesterday's Chart Advisor issue, lower interest rates for a longer period will hurt bank profits unless economic growth (and demand for borrowing) picks up. What is most promising about today's rally is the support of big tech stocks – they usually lag the major indexes when interest rates are falling.
Risk Indicators – Uneven Returns
I have spent a lot of time over the past two months discussing the negative outcomes that tend to follow a period when stocks are rising and longer-term interest rates are falling. However, a long-term divergence between stocks and interest rates isn't unprecedented. For example, the two asset classes moved in opposite directions like this from March through September of 2017.
What we learn from similar periods of interest rate and stock price divergence is that the market returns still tend to be uneven. While the S&P 500 index still rose through 2017, interest rate-sensitive sectors such as banks lost value. The most significant gains were experienced in normally steady groups like utilities.
The following chart compares the performance of the S&P 500, the SPDR S&P Regional Banking ETF (KRE) and the Utilities Select Sector SPDR ETF (XLU) during the 2017 divergence. I think there are two important lessons from this period that apply to the market in 2019.
- Bull markets are persistent, but returns in a low interest rate environment can be disproportionately good for income stocks (e.g. utilities) over banks and brokers.
- Divergences eventually reconcile themselves, which means volatility may still be on the horizon for late 2019. The 2017 rally ended, and the market experienced a major correction in the first quarter and a bear market in the fourth quarter of 2018.
Bottom Line: Trade and Transportation
Although the S&P 500 is looking better after the Fed announcement, the transportation sector has not confirmed the breakout yet, and it is unlikely to do so for a while. FedEx Corporation (FDX) reported earnings on Tuesday afternoon and pointed toward weakness in China as a major issue for growth and profitability.
President Trump's trade dispute with China and new threats of indefinite tariffs will likely weaken transportation companies further, which will hurt related industrial stocks. As usual, the U.S./China trade negotiation remains one of the two biggest x-factors facing the market. Positive news for Brexit or trade could make a big difference for confidence in the near term.
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