This summer’s fears about escalated trade tensions, slower global growth, and the inverted yield curve have let up somewhat as the year has progressed. Economic mood swings have become commonplace, however, with the trade standoff with China intensifying or de-escalating with the speed of a tweet or offhand comment.
Despite this turbulence, the economy has shown great resilience. Growth has slowed but remained strong enough to keep the unemployment rate from rising. Hiring slowed in August and factory activity eased, while consumer spending remained strong. Businesses have grown more cautious, however. Capital spending has slowed, particularly considering the inverted yield curve and all the subsequent speculation about a possible recession. But a recent batch of housing data has pointed to a firming U.S. economy.
The erratic nature of trade talks has undoubtedly contributed to a falloff in consumer confidence. The Conference Board’s index fell by the most in nine months in September to 125.1, from a downwardly revised 134.2 the month before. This downturn in expectations could see consumers holding back on spending. Indeed, consumer spending slowed more than expected in August, nudging up just 0.1% month-on-month. On the upside, incomes rose by a solid 0.4%. Price pressures were steady, with PCE inflation holding at 1.4% year-over-year, but the core measure ticked up to 1.8% from 1.7%.
The Federal Reserve has cut its benchmark interest rate by a quarter-percentage point for the second time in as many months to cushion the economy against a global slowdown amplified by the U.S.-China trade war. The Fed has essentially taken out insurance with these rate cuts to prevent those risks from turning into something bigger.
Global economic growth has continued its gradually slowing path as U.S.-China trade tensions have persisted, Brexit issues have remained unresolved and monetary easing by several major central banks has yet to have much effect in terms of stabilizing and strengthening global economic activity.
While the underwhelming performance of the major economies has contributed to slower growth, some key emerging economies have also contributed to a less favorable outlook. China’s economy has remained on a slowing path, with export growth turning negative in U.S. dollar terms. India’s economic growth has been very disappointing during the first half of 2019, though, unlike China, some recovery is expected.
Consumers slowed spending and businesses cut back on investment in August, signs a wobbling global economy and rising tariffs have curbed U.S. economic momentum. Much of the slowdown in consumer outlays in August could be traced to lower energy prices, which magnified a pullback in spending on gasoline and other energy goods.
Personal-consumption expenditures edged up a seasonally adjusted 0.1% in August from July. The modest growth marked a sharp pullback from the first seven months of the year when spending rose an average of 0.5% a month. Incomes grew 0.4% in August from a month earlier, led by a 0.6% jump in employee compensation. Annual inflation also remained low, undershooting the Fed’s 2% target.
American consumers had been a bright spot in the economy, but weaker August spending showed consumers might be succumbing to some of the external headwinds that have shaken businesses and manufacturers for months.
Residential investment could be likely to add a small, but positive amount to third-quarter GDP – a welcome development after several quarters subtracting from growth. New home sales increased 7.1% in August and pending home sales rose a better-than-expected 1.6%. On the supply side, housing starts rebounded strongly in August following several months moving sideways. Total housing starts jumped 12.3%, the highest since June 2007, while existing home sales rose again in August, marking the first back-to-back increase since 2017.
The decline in mortgage rates has boosted sales and firmed prices, while lower short-term rates have helped homebuilders. Despite this, builders have been cautious, wary of trade policy uncertainty and stock market volatility leading to a sudden pullback in demand. Still, the stronger sales pace and improving builder confidence should feed through to stronger construction later this year.
Should an increase in supply be sustained it would help alleviate existing inventory pressures, which have started to show up in accelerated price growth, reducing some of the past improvement in affordability.
The Federal Reserve cut interest rates as insurance against the risk that the global slowdown could deepen and spread, amplified by geopolitical factors such as trade tensions, Brexit debate, Saudi Arabia-Iran tension and political unrest in Hong Kong.
The Fed left the door open for additional cuts amid the costs of rising trade-policy uncertainty. However, the trade-related risks have been out of the Fed’s control and difficult to predict, and the Federal Open Market Committee (FOMC) members have been divided over how to respond. The Fed appeared split between those who believe the global situation is going to keep slowing the U.S. economy and threaten to unleash disinflation, versus those who view the world as background noise and focus on domestic variables.
While the direct impact on U.S. economic growth from the China trade standoff has remained minimal, most of the risks to U.S. economic growth have continued to emanate from overseas. Slower growth and rising uncertainty in China have weighed most heavily on nations more exposed to international trade, such as Germany, Japan, Korea and much of the developing world. The resulting slowdown in global growth has weighed on U.S. exports.
The indirect effects of the trade standoff have been more difficult to quantify and have mainly manifested themselves through increased uncertainty, weighing most heavily on business fixed investment. Financial market volatility has also increased, as a large proportion of corporate earnings have come from overseas. The widely reported inversion of the yield curve and surge in recession concerns also mostly emanated from overseas. With over $15 trillion of debt now carrying a negative interest rate, demand for higher-yielding U.S. debt has increased, pulling long-term yields sharply lower.
New research from the Fed estimated uncertainty over trade policy could reduce U.S. economic output by more than 1% through early 2020. If trade uncertainty should persist, a chill over business investment could eventually lead to a hiring pullback that damages consumer confidence and spending. This would threaten the main pillar of the U.S. economy.
The escalating trade war between the U.S. and China has rippled through the global economy, hurting confidence among U.S. small businesses, crimping trade among industrial giants in Asia and hitting export-oriented factories in Europe.
Tariffs have put upward pressure on costs for multinational companies, forcing them to look for ways to offset it. Moreover, uncertainty about the outlook for negotiations between the U.S. and China has made it difficult for managers to plan.
The ISM’s manufacturing index decreased to 49.1 in August from 51.2 in July U.S., the latest sign that a global manufacturing pullback has spread amid rising trade tensions. Readings below 50 indicate contraction.
Softness in the U.S. manufacturing sector has created concern, as it could be a harbinger of a broader economic slowdown. In the current context, manufacturing weakness appeared less related to domestic issues, and more to global factors, specifically, elevated trade uncertainty and slowing global growth. Indeed, the deepest declines in manufacturing shipments have been concentrated in sectors that are relatively more export intensive.
Yield Curve Inversion
Yields on the 10-year U.S. Treasury bond have fallen below many short-term yields, resulting in an inverted yield curve. In the past, yield curve inversions have often preceded economic downturns. However, the current situation has been somewhat different.
Previously, most of the yield curve inversions were driven by the Federal Reserve raising short-term rates well above the level expected to prevail, to slow the economy down and prevent inflation from accelerating. Today, the federal funds rate has been at a level roughly equal to Fed’s 2% inflation target and still below its expected level in the long run. Rather than policy actions by the Fed that have raised the short-term rate, what is currently driving the yield curve inversion has been the decline in the long-term rate.
The depressed long-term yield, in part, reflected the challenging economic conditions in much of the rest of the world. Currently, U.S. government bond yields are higher than those in most other developed countries. This has provided an incentive for foreign investors to buy U.S government securities, especially if the risk of a dollar depreciation is perceived as low. But such an increase in demand has pushed the prices of U.S. government securities up and yields down.
The loss of nearly 6% of global oil output in the September 14th drone strikes in Saudi Arabia risked jolting energy markets and raising prices for U.S. consumers. A significant boost in prices would be a shot in the arm for U.S. shale producers, who have been under tremendous pressure from investors to restrain spending and focus on profits. In the near term, the biggest effects would be felt in Asia, estimating that China, Japan, India, Korea, and Taiwan have accounted for about four million barrels a day of consumption of crude from Saudi Arabia.
But as luck would have it, the attack came as global oil stockpiles were higher than usual, several producing countries have ample spare capacity and American oil facilities have so far been spared from a damaging hurricane season. Meanwhile, a slowing global economy has moderated energy demand. Therefore, no supply-demand imbalance would be expected in the near term.
Some key emerging economies have contributed to a less favorable global outlook. China’s economy has remained on a slowing path. Chinese export growth has turned negative in U.S. dollar terms. China’s activity data and confidence surveys have also been mixed, prompting the Central Bank to again reduce its reserve requirement ratio in September to foster lending. That said, China’s policy response to its economic challenges will likely be calibrated to cushion the growth slowdown, as opposed to generating a growth recovery. Thus, while China’s GDP growth has been forecasted to be 6.1% in 2019, growth could slow to 5.8% in 2020.
Another disappointment among the emerging economies has been India, which has seen GDP growth slow precipitously to 5.8% year-over-year in Q1 and 5.0% in Q2, from 6.6% in Q4-2018. Political and policy uncertainty, along with a less favorable monsoon season this year, have been factors driving India’s slowdown. As a result, India’s economy should grow only 5.5% this year, although, in contrast to China, some recovery for India’s economy in 2020 appears likely.
How should the relatively good domestic economy and forecasts for the second half of this year be seen against significant risks from trade, a slowdown in some trading partners, and the low long-term rates creating an inverted yield curve? At times like this, it is important to carefully study incoming economic data. If the risks become pronounced and threaten the U.S. outlook, then further monetary easing may be appropriate. However, if the data continue to indicate a U.S. economy growing slightly above the level considered to be the economy’s potential growth rate, with continued gradual increases in wages and prices, then no immediate policy action will be required.
The gradual slowing of GDP growth is not that surprising – and is not necessarily a signal of a weakening economy headed for a recession, but instead a natural pattern. As resource constraints, e.g., the availability of workers, become more binding and the effects of the fiscal stimulus wane, and with monetary policy only marginally accommodative, actual economic growth should settle in the vicinity of the growth rate associated with the economy’s potential.
The outlook continues to be shaped by expectations that a truce will eventually be found in the trade dispute, which will reduce some of the uncertainty hanging over the economy. Domestic demand is holding up well and continues to maintain strong momentum, given the higher levels of employment, solid income growth and strong position of overall household and corporate balance sheets. The inverted yield curve is a warning, however, that even the less globally exposed U.S. economy is not immune to the effects of slower global growth.
A forecast for 2019 real GDP growth of around 2.2% is reasonable given the developments of the first three quarters of 2019. However, the longer-term economic outlook remains uncertain due to cooling global growth, a faltering manufacturing sector, and the fading effects from the 2017 tax cut and trade frictions.
Concerns over tariffs and geopolitical uncertainties have increased discussion around a possible economic downturn. However, to date, these elevated risks have not become a reality for the U.S. economy.
Global economic growth has continued its gradually slowing path as U.S.-China trade tensions have persisted, Brexit issues have persisted and monetary easing by several central banks has yet to stabilize and strengthen global economic activity. Global GDP growth should slow to around 3.0% in 2019.
Trade has not been the only geopolitical wild card. Risks are also coming from the U.K.’s coming departure from the European Union, political unrest in Hong Kong and an attack on a major Saudi Arabian oil processing hub that roiled global markets.
Capital Market Commentary
The third quarter was marked by ongoing concerns about slowing global economic growth and policy uncertainties, particularly those related to trade relationships. The period saw investor appetite for risk fall and market conditions remain volatile. Growth concerns and dovish central banks action drove global interest rates downward. Despite worries, U.S. equity markets produced a modest gain during the quarter. The benchmark S&P 500 rose 1.7% and closed the period within 2% of an all-time high. The Dow Jones Industrial Average was up 1.8%, and the Nasdaq closed 1.3% higher. Results overseas were largely negative as the MSCI EAFE index fell 1.1%, and the MSCI Emerging Market Index dropped 4.3%. Fixed income markets were mixed. The Barclays U.S. Aggregate Bond Index gained 2.3%, while the Barclays Global Aggregate ex. USD Bond Index fell 0.6%.
U.S. equities generated modest gains in the third quarter amid ongoing growth concerns, uncertainties surrounding U.S.-China trade relations, and geopolitical friction. These uncertainties weighed on business sentiment and triggered volatility. August 5th produced the largest one-day market drop of the year. As expected, the Federal Reserve cut rates following its July and September meetings. Markets reacted with disappointment, however, to Fed comments implying these rate cuts were only adjustments rather than the start of an easing cycle. The quarter saw the 10-year to 2-year Treasury yield curve invert for the first time since 2007, magnifying concerns that the economy may be headed for a recession. Second-quarter corporate earnings season although unspectacular, met expectations. Overall, it was generally a “risk-off” quarter led by less economically sensitive market sectors. Utilities were up more than 9%, real estate gained almost 8%, and consumer staples rose more than 6%.
Developed international equity returns trailed those generated in the U.S. and were negative for the quarter while emerging markets produced a loss of more than 4%. European equities, as measured by the MSCI Europe Index, dropped nearly 2% during the period. The macro-environment remained uninspiring as the Eurozone economy expanded just 0.2% in Q2. In September, the European Central Bank took steps to boost the economy, including restarting quantitative easing and committing to buying assets until its inflation target is reached. The MSCI UK Index fell 2.5% during the quarter as many economically sensitive areas of the market performed poorly. Uncertainties surrounding Brexit remained at the forefront as Boris Johnson took over as the UK’s new prime minister. In Japan, investors enjoyed a quarterly return of 3.1%, driven by a strong September. Prime Minister Abe’s Liberal Democratic Party won the Upper House elections in July, confirming continuity of policy for the foreseeable future. Trade negotiations between the U.S. and Japan appeared to progress positively. Emerging markets produced a 4.3% loss during the quarter. China, the index’s largest constituent, dropped 4.7% as the Chinese economy continued to slow. The manufacturing sector suffered while employment indicators pointed to a slowdown in hiring. In terms of stimulus, there were several announcements from the Chinese government regarding new measures. Evidence of these efforts, however, have yet to show up in the reported data.
Government bond yields fell during the quarter as investors sought safety, particularly during August when U.S.-China trade tensions escalated. The U.S. 10-year Treasury yield fell more than 30 bps and finished the quarter with a yield of 1.67%. Overseas, the 10-year German bund yield fell 24 bps and finished the quarter at a negative 0.57% yield. The 10-year UK gilt yield dropped 34 bps during Q2, with most of this decline occurring in July. U.S. corporate bonds outperformed government bonds, and investment-grade corporates outpaced their high yield counterparts. The global stock of negative-yielding bonds is now more than $15 trillion.
Overall, markets are expected to remain volatile as the calendar turns from 2019 to 2020. In the near term, economies and markets should continue to be driven by trade disputes, geopolitical friction, domestic politics, and central bank action. Protectionist policies have taken a toll on corporate sentiment, and business spending has slowed. Given this environment, returns are likely to be driven more by earnings growth than by further investor enthusiasm. Late cycle dynamics imply that risks to the downside probably outweigh the potential upside. It may be appropriate for investors to reduce risk and emphasize quality. The sources of total investment return may be more balanced between income and capital appreciation then has been the case in the recent past.
In the U.S., given the 2020 U.S. election-year politics, an eventual trade deal may become a more likely scenario. Removing this uncertainty by year-end has the potential to drive the global economy higher. If this occurs, U.S. equities should rally but lag their international peers in that grind higher, which currently trade at more attractive valuations. The failure to resolve trade issues and a further escalation of tariffs have the potential to tip the U.S. and global economies into a recession.
International developed equity markets lagged their U.S. counterparts in 2019. The manufacturing sector has suffered. The services sector, on the other hand, has shown strength, driven by a resilient consumer. Despite the short-term worries, international equities do offer some long-term positives. A dovish shift by the European Central Bank bodes well for European stocks. And the outlook for a weakening U.S. dollar is a positive. Finally, international stocks are currently trading at a greater discount to their long-term average than U.S. stocks.
Some exposure to emerging market equities may be appropriate, but the short-term risks suggest that caution is prudent. An accommodative Fed is certainly a tailwind for this asset class, particularly for those countries with large external debt loads. Many of the world’s other central banks are also easing. Chinese stimulus should also be a benefit to emerging markets. Finally, valuations are generally attractive. On the other hand, emerging economies face the near-term risk of an escalation of trade conflicts. And there is a risk that the Chinese stimulus fails to meet the market’s lofty expectations. Long-term, emerging markets do offer a rapidly growing middle class that should drive above-average economic and earnings growth.
The fixed income environment is likely to be characterized by central bank easing, ongoing trade uncertainty, record low government bond yields, and a high level of volatility. Given this environment, investors may be tempted to reach for yield. Investors should be mindful that higher yield typically comes with higher risk, and often a greater correlation to equities. Fixed income products with a high correlation to equities are less effective in their role as an agent for portfolio risk control. In an environment of slowing growth and rising risks, taxable bond portfolios may benefit from an emphasis on quality and a shift to longer durations. Municipal bonds enjoy favorable supply/demand dynamics, improved fundamentals, and tax reform-related tailwinds. That said, municipal valuations, however, appear a bit stretched. A slowing economy raises concerns about the potential for rising default rates in the high yield markets.
Sources: Institute for Supply Management, the Conference Board, Department of Labor, Department of Commerce, Morningstar, Federal Reserve of St. Louis, Federal Reserve Board, Bloomberg
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