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Recap


The U.S. economy got off to a sluggish start in the second quarter, with both consumers and manufacturers pulling back in April and May amid trade tensions, a global slowdown and the waning effects of the 2017 tax cuts. Retail sales fell a seasonally adjusted 0.2% in April from March. The decline in retail sales was partly because tax refunds weren’t as generous as consumers expected, prompting households to put off major purchases. It could have also been a sign that households were rattled by the trade dispute between the U.S. and China.



Orders for durable goods tumbled 2.1% in April, painting a weaker picture of U.S. factory demand than anticipated. Some of the recent manufacturing contraction was likely due to the large buildup in inventories in the first quarter. That means factories have not produced as much to meet demand. But the persistent weakness since the start of the year has suggested American factories have been squeezed by trade tensions, a weaker global economy, and a strong dollar, which has made U.S. exports more expensive in world markets. A closely watched measure of U.S. freight demand has also sent a troubling signal – it dropped in April, the fifth straight month in negative territory.

Bond yields have slid in recent weeks in response to a host of factors, including tepid economic data, geopolitical tensions and signs of caution from the Federal Reserve. This has reflected a growing concern among investors that global economic growth has slowed and U.S. economic growth could falter as the effects of Trump administration tax cuts fade, companies cut back on spending and higher tariffs restrict global trade.

The sudden re-emergence of concerns about U.S.-China trade tensions and now Mexico has highlighted the ever-looming risk of geopolitical uncertainty. Moreover, sentiment surveys from the Eurozone and China have painted a picture of still-tepid confidence, and it may be some time before these economies display more concrete signs of stabilization. In the United Kingdom, Q1 GDP data have shaped up to be quite strong, but largely as a result of temporary pre-Brexit stockpiling, suggesting some payback in Q2.

With the global economic outlook still somewhat fragile, most central banks have seemed to be comfortably on hold. The Bank of Canada (BoC) removed its explicit rate hike bias at its April meeting, and as a result, a BoC rate hike is no longer expected. Meanwhile, the Bank of England (BoE) has suggested rates may have to rise faster than markets have currently expected, but it cut its inflation forecast, and any BoE hike in rates would likely be postponed at least until next year given lingering 2019 Brexit uncertainty. With interest rates on hold at low levels in most major economies, the global economy appears to have some breathing room to regain its footing.

Housing: The recent pickup in the housing market remained on track. Housing starts rose 5.7% in April. Building permits also improved. However, declines in both new and existing home sales during April have masked an overall improving trend in the housing market. A significant breakout is unlikely this year, but the pullback in mortgage rates, lower material costs, and improved builder sentiment should help keep the rebound in residential construction intact.

Durable Goods: Orders for durable goods tumbled 2.1% in April from the prior month. Much of the decline was due to the volatile civilian-aircraft component. But the aircraft sales were just one piece of a broader picture. The new data has followed others showing recent broader declines in factory output and business activity, suggesting the economy has lost momentum.

Though manufacturing accounts for a small share of gross domestic product, the sector has been highly sensitive to shifts in demand, making it a bellwether for the broader U.S. economy. The outlook for capital investment is unlikely to improve in the near term given the Trump administration’s decision to increase tariffs on goods imported from China. While the full impact has remained unclear, the tariffs could disrupt complex business supply chains and drive up prices for at least some consumer goods.



Oil Price: Oil prices have staged a steady recovery since the start of the year, rising by more than 50% from their December lows. While a good part of the comeback has been traced to broad improvement in risk sentiment, a tightening in the supply-demand balance for crude has suggested that recent price levels are sustainable. The outlook for oil demand has been mixed. Demand growth has been weakening recently, especially in the Organization for Economic Co-operation and Development (OECD) countries. Still, fears of a protracted global slowdown have moderated and expectations for 2019 have pointed to improving growth. Supply-side factors, however, have taken center stage. The Organization for Exporting Countries (OPEC) compliance in implementing a 1.2 million barrel per day cut and involuntary reductions in other countries have been the key driver in supporting a return to a somewhat more balanced market. OPEC spare capacity, together with the persistent rise of U.S. shale production and its relatively low break-even costs should serve to put a ceiling on any meaningful price acceleration from here.



The outlook for West Texas Intermediate crude oil (WTI) has remained in a relatively flat, range-bound profile between US$60 to US$65 per barrel throughout 2019. Upside risks to this have mostly centered on wildcards, namely supply disruptions, and geopolitical factors. This included further drops in Venezuelan output, disruptions in Libya and Nigeria, or a larger than expected impact of Iranian sanctions on the crude market, which could force higher the risk premium implied in the price of oil. On the downside, the most notable risk has been a deeper than projected slowdown in global growth as well as a renewed wave of pessimism in global financial markets.

U.S. China Trade Tension: As trade tensions between the U.S. and China have ratcheted higher, both countries have exchanged fresh threats of raising tariffs leading to sharp stock market swings. Escalating tariffs between the U.S. and China should begin hitting businesses and consumers on both sides of the Pacific.

There is still time for the U.S. and China to carve out a trade agreement as the two countries’ increased tariffs should not hit goods in transit immediately. However, a breakdown of trade talks could risk damaging confidence among businesses and consumers, potentially crimping spending at a time when U.S. economic growth has already been expected to moderate.

If there is no resolution to this trade war, the end result would likely be a “stagflationary” situation – slow growth with rising inflation. That would put the Federal Reserve (Fed) in a tough spot—would they cut rates even as inflation rises? That is a possibility because tariffs have been more of a one-way inflation spike, as opposed to a continuous, generalized increase in the prices of all goods and services. In addition, the Fed would likely be confident that a weakening economy would eventually put downward pressure on inflation. Stocks would certainly struggle in this scenario, at least until the Fed came to the rescue. And the yield curve would steepen due to Fed easing.

If an agreement is reached, stocks could be off to the races, unless President Trump then pivots his protectionist trade agenda to the European auto market. Assuming that does not happen, the dollar should fall, commodity prices should rise, and term premiums could increase. Either way, the yield curve would be more likely to steepen than flatten.

United Kingdom: The Brexit saga came back to the fore, as Prime Minister Theresa May announced her resignation. May had been unable to get her negotiated Brexit deal through parliament. The way forward on Brexit has remained unclear, and the new Conservative leader, who should be selected by the end of July, will not have a lot of time to chart a new course before the Oct 31st deadline for Britain to leave the EU. In the meantime, the cloud of uncertainty has continued to hang over the UK economy.

Interestingly, the U.K. economy has picked up speed at the beginning of 2019, as businesses have readied for the country’s now delayed exit from the European Union, though prospects for the year as a whole have remained muted as uncertainty over Brexit drags on. The British economy has expanded at an annualized rate of 2.0% in the first quarter, up from 0.9% in the final three months of 2018.

Factory orders have boomed as both domestic and overseas customers raced to stock up on British-made products before the U.K. had been due to leave the EU. The extra demand offset a drag on first-quarter growth from a sharp rise in imports, as British firms and households, also mindful of any Brexit-related disruption, have sucked in foreign goods.

The boost to growth from stockpiling in the first quarter will likely mean weaker growth in the months ahead, as companies work through their swollen inventories. Quarterly growth has been expected to slow to 0.2% in the second quarter. With businesses expected to largely sit on their hands until Brexit is resolved, the economy would again rely on household consumption to power growth. The U.K. is expected to post growth in 2019 of 1.3%.

Eurozone Economy: The Eurozone economy regained some lost momentum at the start of 2019, offering fresh evidence of surprisingly resilient global growth amid lingering uncertainties about trade with the U.S. and the strength of demand for its exports from China. The combined GDP of the Eurozone’s 19 members increased by an annualized 1.5% in the three months through March, an acceleration from the 0.9% rate of growth recorded in the final quarter of 2018. Compared with a year earlier, GDP was 1.2% higher.

The currency area has suffered from a combination of headwinds, including falling demand from the troubled Turkish economy, uncertainties about the timing and form of the U.K.’s departure from the EU, and tensions between the U.S. and its main trading partners. Those headwinds have fed deepening pessimism among the Eurozone’s manufacturers as their expectations for export sales have weakened.

The economic slowdown that deepened in the second half of last year has prompted a change of plan at the European Central Bank, which has put off plans to raise its key interest rate this year, and has announced that it will offer a new round of cheap loans to banks in September, underscoring deepening concerns among policymakers over a slowdown that has dragged on for longer than expected.

Outlook: Unease about U.S. economic performance is building for good reason. Economic growth is set to moderate this year after a stimulus-fueled 2018. Foreign demand remains weaker than last year, while geopolitical risks and trade policy uncertainty appear to be on the rise.

Moreover, high-frequency indicators are beginning to diverge. Domestic demand remains resilient, but externally oriented industries are combating stronger headwinds. Data for retail sales and housing starts for April support the view that the domestic economy remains healthy. Although retail sales pulled back in April, this came after a very strong March. Some payback was to be expected. Even with the decline, the strength in March, alongside continued income gains, support a very healthy 3% quarterly annualized rate of expansion in consumer spending in the second quarter.

Housing starts, on the other hand, surprised to the upside. After December’s dip, housing starts appear to have regained stronger footing, but activity has been choppy through April. Homebuilder sentiment is improving as well, reaching a 7-month high in May. Moderating home price growth, combined with lower mortgage rates, rising wage growth, and decades-low vacancy rates should support more homebuilding in the months to come.

All told, the U.S. economy has been expected to expand at about a 1.5% annualized pace this quarter, largely on the back of a more confident consumer. That said, signs continue to build that this may be as good as things get for the rest of this year. Cracks are beginning to appear in what was previously a very resilient manufacturing sector. Industrial production has contracted 0.5% in April, the third monthly contraction this year. This mirrors the declining pace of output reported in the ISM manufacturing survey. Although manufacturing has been a relatively small share of the U.S. economy (about 11%), its performance is still considered a harbinger of the direction of the U.S. economy largely due to its sensitivity to changes in foreign demand. On that front, there are some signs that the global economy is slowly improving. However, escalating trade and geopolitical risks threaten to derail this nascent recovery.

Sources: Department of Labor, Department of Commerce, Bank of Canada, UK Office for National Statistics, European Central Bank, Bloomberg, Morningstar


Disclosures:
Past performance quoted is past performance and is not a guarantee of future results. Portfolio diversification does not guarantee investment returns and does not eliminate the risk of loss. The opinions and estimates put forth constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

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