The U.S. economy has taken a bit of a rollercoaster ride. Some signals have suggested that the downside risks to growth are rising, necessitating further support by the Federal Reserve. Others have indicated that the economy is doing just fine, and stepping on the gas might not be warranted. The service sector has kept expanding and consumers have spent briskly. But manufacturing output fell in the first four months of the year and the housing market has remained soft. Trade concerns have clouded business certainty on investment spending and perhaps hiring plans. Consumer confidence has also been hit. The employment figures added to other data has depicted an economy that is still growing but is losing momentum after the first quarter of 2019 and last year.
Federal Reserve officials have followed these mixed signals as they have considered whether to cut interest rates in the coming months. They have been watching closely for signs the economy might be slowing more sharply than expected amid uncertainties related to geopolitical risks or the cooling global economy.
Markets have priced in the risks emanating from the trade conflicts, resulting in a continued inversion of the yield curve, and an expectation of at least two Fed interest rate cuts by the end of the year.
However, trade uncertainty has not yet seemed to weigh on business optimism. The NFIB small businesses optimism index has improved for the fourth consecutive month as businesses anticipated an improvement in economic conditions and more capital expenditures in months to come.
American shoppers ramped up their spending in May, providing critical fuel for the U.S. economy’s continued expansion despite trade tensions and slowing global growth. Retail sales rose a seasonally adjusted 0.5% in May from a month earlier. Consumption growth has now exceeded the annualized 3% mark in Q2.
These sources of resilience have helped to offset some soft spots in the economy. Despite the strength in consumption, CPI inflation weakened in May. The weakness in inflation in Q1 appeared to be less transitory. Core inflation declined for a range of products including used cars and trucks, apparel, and motor vehicle insurance. While inflation may pick-up going forward, given the increased tariffs on Chinese imports, underlying price pressures in the economy seem to be limited. Among the U.S. economy’s other pockets of weakness have been recent slowdowns in hiring, downward drifts in consumer confidence, tepid rebounds in manufacturing and soft housing markets.
The global growth backdrop has also remained tepid heading into the summer. The Eurozone economy has continued to teeter on the edge, with economic growth neither fast enough to reassure officials at the European Central Bank (ECB), nor slow enough to warrant more monetary stimulus. China has faced headwinds from another escalation in the trade dispute. There has also been a rise in global political risks as the relationship between the U.S. and Iran has become increasingly strained. The oil markets could get caught in the middle.
U.S. optimism about the economy deteriorated in June to its lowest level in 21 months as consumers fretted over escalating trade tensions and a cooling jobs market. The consumer confidence index fell to 121.5 in June, a nearly 10 points drop from May and was the index’s lowest level since September 2017.
The escalation in trade and tariff tensions earlier this month appears to have shaken consumers’ confidence. Although the index has remained at a high level, continued uncertainty could result in further volatility in the index and, at some point, could even begin to diminish consumers’ confidence in the expansion.
Employers tapped the brakes on hiring in May, signaling companies were taking a more cautious approach at a time of cooling global growth and trade tensions and underscoring a spring slowdown in the decade long U.S. economic expansion. The economy added 75,000 jobs in May, marking the 104th straight month of gains, but also one of the weakest monthly increases since 2009. The hiring slowdown was broad-based across industries. The unemployment rate held steady at 3.6%, a near 50-year low. Low unemployment has created a competitive landscape for companies who must fill job openings, but face an increasingly scarce supply of workers to choose from.
Hiring has been expected to slow as the expansion ages. There are simply fewer people available to fill job openings, pushing job growth to slow, in line with trend growth in the labor force of around 120,000 per month. However, this slowing has been more abrupt than expected. It could signal that the weakness seen in business confidence measures and in investment spending could now be showing up in hiring.
The ISM manufacturing index fell to 52.1 in May from 52.8 in April, a two and a half year low. Employment held up, but production slowed and backlogs of orders declined. There were a few signs of the escalation in trade tensions with China weighing on activity and sentiment, based on respondent comments.
Manufacturing activity has slowed considerably over the past several months. With trade tensions escalating, further weakening in the ISM index has been a real possibility. A decline in U.S. manufacturing activity could be attributed to a pullback to several factors, including escalating trade tensions, cooling global growth, slowing momentum a tight labor market that is constraining production.
If the perception of risk prevails that supply chains have been slowed or disrupted, investment is put off and real consumer spending suffers amid the widening net of tariffs raising. This development could raise concerns that weakening in the manufacturing space may be a harbinger of weakening in the broader economy.
The U.S. service sector expanded in May, providing key fuel for the broader economy in the face of cooling global growth and rising trade tensions. The ISM non-manufacturing index rose to 56.9 in May from 55.5 in April.
This would fit with other signs that the overall economy has expanded at a good pace this spring, though more slowly than last year and despite some weak spots. Services accounted for about 88% of U.S. gross domestic product.
The domestic economy has still been resilient and on solid footing. For now, there appears to be no sharp downshift in economic activity, but second-quarter GDP growth could be soft and that would be due to inventory and trade.
The sharp drop in mortgage rates this past month would normally be a panacea to a housing market that has stumbled recently under the weight of diminished affordability. Unfortunately, the latest drop in mortgage rates has not been enough to overcome the rising anxiety among potential homebuyers who have sensed that lingering trade tensions are putting economic growth at risk. The increased regulatory zeal in the technology sector has also crimped home buying, as rising antitrust momentum will soon make it more difficult for startups to raise capital, slowing growth in the fastest growing parts of the economy. Demand for refinancing existing mortgages has been perking up, however, which would redirect household cash flow toward home improvements and consumer spending in general. Lower mortgage rates have bolstered homebuilder confidence, and sentiment among potential home buyers has also improved. Unfortunately, the affordability paradox facing potential buyers has not eased enough to provide a significant boost to home sales. Modest gains in home sales and housing starts are still expected this year, but rather than igniting a resurgence in home buying, lower mortgage rates should merely cushion the blow from slower global economic growth. Consumers have felt reasonably optimistic about their employment and income prospects, which should provide some support for home buying.
The Federal Reserve
The Federal Reserve held interest rates steady in their June meeting while indicating a rate cut could come soon, a notable shift from just two months ago when it saw no case for any rate adjustment. Several developments have been cited for this change in policy: inflation has been below the Fed’s 2% target and shown no signs of accelerating; commodity prices have gone from stable to declining, a downturn in indicators of global growth; a strong dollar as the global demand for dollars has been high; and a worsening of trade tensions, which are all dampening confidence throughout the world, not just the U.S.
The Federal Reserve has seen the recent escalation of the U.S. trade dispute with China as a rising risk to the U.S. expansion, complicating its current status-quo policy posture. If the China trade conflict has not been resolved soon, the patience needed to keep from easing will be severely tested sometime in the months ahead.
Generally speaking, the Fed may choose to move more quickly than it has in previous cycles to shore up growth at the first sign of any economic contraction because with its short-term benchmark at a historically low range, between 2.25% and 2.5%, it would not have as much room to cut rates as in previous downturns. But the trade-fight scenario has been messy because it involved making assumptions around harder-to-predict geopolitical risks.
The European Central Bank (ECB) signaled the rolling out of fresh stimulus as soon as July. Options included extending the time frame before the next interest-rate increase, a reduction in the already negative policy rate, or restarting bond purchases.
This would raise the prospect of a “nightmare scenario” in which the ECB and Federal Reserve engaged in a race to the bottom on exchange rates, creating economic damage that could be aggravated by trade tariffs.
The ECB has not been alone in considering fresh stimulus. The world’s major central banks have rapidly shifted gears in recent months, shelving plans to increase short-term interest rates and seeking instead to ease policy amid signs that the global economy has been softening. Many central banks in the Asia-Pacific region, including New Zealand and Australia, have already reduced interest rates in recent weeks.
The pace of U.S. economic growth remained at a strong 3.1% annual rate in the first three months of the year, but a downward revision to consumer spending suggested the momentum could be difficult to maintain in the second quarter. Sectors of the economy tied to trade, manufacturing and housing appeared to be struggling with uncertainties related in part to overseas trade tensions. The manufacturing sector has contracted in the first four months of the year, the housing market has remained soft and trade tensions have escalated. Slowing global growth and weak inflation have also clouded the outlook for the rest of the year, prompting the Federal Reserve to signal it might cut short-term interest rates in the months ahead to give the economy a boost.
A pullback is expected in second-quarter growth with the economy expanding at a 1.5% annual rate in the April through June period. Expectations for a second-quarter slowdown are tied to factors such as the waning stimulus effects of tax cuts, government spending increases and weakening global economy. Some boosts to growth in the first three months of the year, like inventory investment and trade, could reverse.
But such a slowdown would not mean a recession is imminent. Strength in the service sector has signaled quite the contrary, acting as a buffer against a sharper slowdown or recession. The service sector has offset some of the weakness that’s coming from manufacturing.
The outlook for economic growth has been scaled back, largely due to the knock-on effects from the lingering trade rift with China. Global trade has slowed, and export-dependent economies like China, Japan and Germany have borne the brunt of that slowdown. The downshift in global economic growth is becoming more apparent in the nation’s manufacturing sector but is also weighing significantly on the energy and tech sectors. GDP is expected to grow at 2.6% this year. Job growth will also be slower but should still be strong enough to pull the unemployment rate modestly lower over the next two years.
With growth slowing, interest rates have fallen substantially over the past month and the yield curve has fully inverted. The Federal Reserve is expected to cut interest rates twice this year, most likely in July and October. The Federal Open Market Committee has largely undershot its 2% inflation objective for most of this expansion, and a rate cut could help it bring inflation expectations more in line with its target. In addition, with limited conventional “ammunition” (i.e., only 225 bps of potential rate cuts) the FOMC may want to get ahead of any economic deceleration with “insurance” rate cuts rather than waiting until more economic trouble surfaces.
Trade tensions between the United States and China have lingered and these tensions may fester for the foreseeable future. Two separate trajectories for the U.S. economy have surfaced amid an escalation of trade tensions in recent months. Under one, trade negotiations would avoid further disruption of global supply chains and prevent drags on business investment. Under the other, worsening trade frictions and weak global growth would lead to a sharper slowdown for the U.S. economy.
Following a first quarter that saw the S&P 500 rise nearly 14%, the stock market continued its upward move in the second quarter. The S&P 500 closed the period near an all-time high despite a sharp drop in May that was driven by concerns over U.S.-China trade policy. Markets were supported by increasingly accommodative central banks and a positive shift in trade sentiment that occurred during the month of June. The benchmark S&P 500 index rose 4.3% during Q2, the Dow Jones Industrial Average was up 3.2%, and the Nasdaq jumped 4.3%. Results overseas were also positive as the MSCI EAFE index rose 3.7%. The MSCI Emerging Markets index produced a more modest 0.6% return. Fixed income markets generated solid returns as global bond yields fell. The Barclays U.S. Aggregate Bond index gained 3.1% while the Barclays Global Aggregate ex. USD Bond index rose 3.4%.
The key themes of 2019 continue to be accommodative central banks and the seemingly daily developments surrounding trade relations between the U.S. and its partners. May’s setback – the S&P 500 dropped more than 6% during the month – was driven by trade concerns as President Trump kicked off the month with tweets expressing frustration with the pace of U.S.-China trade talks and announcing a plan to raise tariffs on Chinese goods. While June’s rally, producing a gain of more than 7%, benefited from optimism surrounding President Trump’s planned meeting with China’s Xi Jinping at the end-of-month G20 summit. While this meeting did not resolve trade tensions dogging the global economy, it also did not exacerbate them. Some progress was made, and the outcome appears to have met investor expectations. In Fed news, the U.S. central bank held interest rates steady following its June two-day policy meeting. Its “dot-plot,” however, signals easier policy ahead. A July rate cut is widely expected.
Developed international equity returns modestly trailed those generated in the U.S., while emerging markets produced only a slight gain during the quarter. Much like the U.S., European equities suffered through a difficult month of May but enjoyed positive results in April and June. Trade-related concerns drove markets while signals from the European Central Bank (ECB) of further monetary policy easing, such as new bond purchases, boosted stocks. Shares in the U.K. performed well, despite significant political uncertainty as Theresa May resigned as leader of the Conservative Party and therefore the country’s prime minister. Japanese equities lagged its developed market counterparts. The MSCI Japan index produced a modest 1% gain during the quarter. Japanese economic data was mixed, the yen strengthened, corporate earnings growth appears to be slowing, and trade-related concerns weighed heavily on Japan’s export-dependent economy. Emerging markets were positively driven by strong quarterly results from Russia and Brazil. The MSCI Russia index was up nearly 17% as its central bank cut rates and signaled the potential for further easing later in the year. And the MSCI Brazil index rose more than 7% during the quarter. These positive outcomes were largely offset by a negative quarter from China. The MSCI China index fell more than 13% during the month of May alone when trade sentiment was most negative. For the quarter, the Chinese stock index fell 4%. Finally, equity returns in India were essentially flat for the quarter.
Government bond yields fell during the quarter, driving market indexes higher. Reflecting the expectation of easy monetary policy, the 10-year Treasury yield fell more than 40 bps while the 10-year German bund dropped more than 25 bps, ending the quarter in negative territory. The 10-year U.K. gilt underperformed, falling about 17 bps for the quarter as yields rose in April on positive economic data and the announced extension to the Brexit deadline. Corporate bonds outperformed government bonds, and higher quality issues fared better than high yield. Emerging market debt produced a positive result for the quarter. Local currency emerging market debt did especially well as the U.S. dollar weakened in June.
Generally speaking, the second half of the year is expected to be more difficult than the first as trade and other geopolitical issues heat up, economic and earnings growth becomes more uncertain, and market volatility rises. An inverted yield curve, trade policy uncertainty, and weakness in global economic data provide an argument for caution. While central banks ease, the Chinese stimulate, and with the potential for a U.S.-China trade deal markets could go higher. It is late in the economic cycle, and downside risks probably outweigh the upside. It may be appropriate for investors to become less complacent and position their portfolio with a more conservative tilt.
In the U.S., the macro environment still looks reasonable for stocks as unemployment remains low and consumer sentiment is strong. However, late cycle dynamics, geopolitical developments, and trade-related issues may drive volatility and hinder multiple expansion. Lacking multiple expansion, any increase in equity prices will have to come from earnings growth, which is expected to only be modest in 2019 and 2020. Equity investments offering both income and possible capital appreciation, such as dividend-paying stocks, may be an appropriate addition to client portfolios as they have the potential to dampen downside risk yet still participate in the upside. An aggressive move into defensive names is probably not recommended as lower rates have left defensive stocks overvalued relative to their cyclical counterparts.
Remaining neutral on developed international equity markets seems to make sense. Early in the year, sentiment improved as it appeared global economic growth would soon stabilize. This positive sentiment was disrupted, however, as trade tensions escalated in May. For the remainder of 2019, lingering trade concerns will continue to dampen global business and investor sentiment. Economic and earnings growth is expected to remain subpar, multiples are likely to be capped, and volatility should continue. Therefore, the upside for international equities may be limited in the short term. Longer term, however, current trade concerns do not change the international story. Growth in Europe should improve, and Chinese stimulus along with central bank easing are positives for the Asia-Pacific outlook. Investors with a below benchmark allocation to international equities may want to consider increasing their exposure as volatile markets offer attractive relative valuations.
Remaining neutral on emerging markets also would appear to be the commonsense investment approach. Again, near term caution is warranted given existing trade policy uncertainty. In the intermediate term, however, emerging markets are expected to benefit from the Chinese stimulus as well as currency appreciation relative to the U.S. dollar. And long term, emerging markets offer a rapidly growing middle class that should drive above-average economic and earnings growth. Today, investors with a longer-term time horizon have the opportunity to take advantage of favorable valuations with the expectation of significant tailwinds in the future.
Impacting fixed income markets, global central banks are widely expected to be accommodative in the face of deteriorating economic data. Investors who have been prepared for rising rates should consider the possibility of falling rates given the potential monetary policy changes. High quality fixed income holdings have the potential to serve as a critical portfolio ballast during late cycle periods. In this environment, it is important that investors fully understand their fixed income holdings as widely held, higher-yielding securities are often more highly correlated to equities and less effective as portfolio ballast. As the economy and earnings growth slows, bond portfolios may benefit from an emphasis on higher credit quality. High yield credit is expensive and losing cycle support.
Sources: Department of Labor, Department of Commerce, Bank of Canada, UK Office for National Statistics, European Central Bank, Bloomberg, Morningstar
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