Highlights:
·The Fed indicated a willingness to cut interest rates in 2019, igniting a second quarter rally in the equity markets.
· A recent ceasefire in the U.S-China trade war was also an assist for stocks, although it remains up in the air whether or not the two countries can work out a long-term deal.
· Trade tensions between the U.S. and China continue to weigh on the Eurozone, who has taken to aggressively forging their own trade agreements in response.
Commentary:
Earlier this month the U.S. economy entered its longest expansion in the nation’s history, but a closer look shows that the hallmark of this expansion has been tepid growth. The economy has been growing at an average rate of just 2.3% per year since June 2009. At this pace, the expansion would have to continue for six more years to equal the cumulative growth of 1991-2001 and nine more years to match the 1961-69 period. The Federal Reserve has repeatedly put off hiking interest rates over the last several years because growth came in below expectations and inflation languished below the Fed’s 2% target. When the Fed finally started raising rates at the end of 2016, it was only able to put through a total increase of 2% over two years before pausing last December due to plunging stocks and trade tensions.
During the most recent quarter, Fed Chairman Jerome Powell took the rate pause a step further, indicating a willingness to cut rates in 2019. Chairman Powell likely realizes that the Fed is low on ammunition with rates already low to begin with at the current target range of 2.25% to 2.5%. For comparative purposes, the rate was 5.25% when the central bank started cutting ahead of the 2008/09 recession. The Fed has typically had to cut rates by about 5% after a recession to stimulate the economy. It would stand to reason then that if there was another recession with rates at current levels, the Fed would only be able to partially revive the economy with rate cuts, before having to turn to more drastic measures such as another round of bond-buying or other unconventional policies such as those used and considered during the most recent financial crisis. As many of these monetary policy techniques are still untested, a scenario where there they would be required is not be desirable.
With this in mind, it is likely that Fed Chairman Powell is eager to head off even the slightest risk of recession than he might otherwise be in a more normal rate environment. In some ways, this mindset is similar to former Fed Chairman Bernanke’s approach to dealing with the immediate aftermath of the financial crisis in which nothing was off the table in an effort to generate inflation and avoid a deflationary cycle such as the one that crippled Japan for several decades. Current Fed Chairman Powell is also likely eager to ensure that the public takes the Fed’s 2% inflation target seriously, since inflation has run mostly under this stated target since 2012. His fear is likely that consumers and business might start expecting weaker inflation, which may become a self-fulfilling prophecy with interest rates near zero and a limited ability to generate higher prices.
Whether the Fed goes through with raising rates or not remains to be seen, but at a minimum they have bought some time and established a more neutral position that allows them to either lower or increase rates in the near future. While President Trump is pressuring Fed Chairman Powell to lower rates and Wall Street investors have seemingly priced in a rate cut, the economy is actually quite strong by most fundamental indicators. The labor market is as strong as it has been in a half-century, with employers ramping up hiring, the unemployment rate at 3.6% and solid wage growth. Consumer spending, which accounts for approximately two-thirds of economic output, continues to be strong, facilitating solid corporate earnings and showing that the U.S. economy appears to be overall on solid footing despite trade tensions and slowing global growth.
Strong economic indicators are at odds with market expectations that central banks will act aggressively to offset worries about weaker global economic growth. The relatively strong economy seems to indicate that the risk of deflation appears limited and has raised concerns that financial markets have grown too dependent on central banks to steer economies through soft patches. This is especially true when threats to growth are coming from areas outside the control of central banks, such as trade conflicts and Brexit. To achieve sustainable global economic growth, at some point monetary policy will need to take a back seat to other policy drivers.
Trade tensions remain a rising risk to the U.S. expansion, although a recent ceasefire on trade between the U.S. and China temporarily eased one of the major short-term concerns for investors. Specifically, the U.S. offered to hold off on additional tariffs on Chinese goods indefinitely and remove some curbs on Huawei Technology that has been a source of contention for China. Meanwhile, China offered to increase purchases of American farm products. That being said, this is not the first time since trade negotiations began that a temporary truce has been reached, and to this point the two countries have not been able to iron out a long-term agreement. It remains to be seen if this time around will be any different. It is also currently unclear on whether this development will have any impact on the Fed’s course of action. What is clear, however, is that uncertainty over trade negotiations is clouding the outlook for corporate profits. This is resulting in many companies tightening capital spending, which is a key driver of economic growth.
Despite China’s claims that its domestic spending will minimize the impact of its trade fight with the U.S., its economy was facing headwinds even before the most recent round of U.S. tariffs. Factory production, retail sales and investment in fixed assets have all slowed this year. China’s leadership has stressed internal strengths to power the country’s economy past its trade trouble with the U.S., but in fact, demand for consumer products has been cooling and real estate and construction have instead been the backbone holding up the Chinese economy so far this year. This contrasts with China’s goal of expanding the buying power of its 400-million-strong middle-income population to make the world’s No. 2 economy more consumer-driven. Nevertheless, China still projects to hit its growth target of 6-6.5% for 2019 if the trade dispute with the U.S. does not worsen this year. While further monetary and fiscal support is likely inevitable, how the trade war plays out will likely determine whether China’s central bank needs to enact new, big stimulative policies later this year.
Meanwhile, Europe’s economy continues to sputter, weighing on manufacturing and exports especially hard. This is a result of the U.S.-China trade fight and the threat of a potentially chaotic Brexit, which was recently exasperated by Prime Minister Theresa May announcing her resignation effective upon the determination of her successor. This has led to signs that the region’s job market is cooling as manufacturers cut back on hiring in response to weaker global demand for their exports. A steady rise in employment has been one of the bright spots for the Eurozone over the last few years and it can ill afford a softening job market if it intends to lift inflation to its target of just below 2%. In response to this darkening economic outlook, the European Central Bank (ECB) signaled that rates would remain low until at least 2020. International Monetary Fund chief Christine Lagarde is the leading candidate to be elected as the ECB’s next president, replacing outgoing chief Mario Draghi whose term ends on October 31st. If approved, Ms. Laragde’s track record of supporting the ECB’s stimulus efforts is believed to pave the way for a continuation of easy-money policies in the Eurozone.
Also providing reason for optimism, the European Union (EU) and South American economic bloc Mercosur (Argentina, Brazil, Uruguay and Paraguay) recently sealed a large trade deal after 20 years of negotiations. The deal aims to make imported products cheaper for nearly 800 million consumers by cutting or removing trade tariffs. This trade deal is now the largest in the world in terms of population, and the latest in a line of trade agreements the EU has made since the U.S. election of President Trump. The EU has also concluded trade agreements with Canada, Mexico and Japan in recent years. While President Trump seems to be spending decades worth of global political capital and replacing long-term global political planning in favor of short-term, bi-lateral deals, the EU continues to show that they stand for long-term rules-based trade.
Nevertheless, it is the U.S. that is celebrating 10 years of uninterrupted economic growth, while the rest of the world continues to suffer through a bear market that is now in its 12th year. Whereas the S&P 500 and Nasdaq both hit their highest closing levels on record during the quarter, stock markets outside the U.S. have still not reached their pre-crisis highs. In this era of globalization, the disjunction between the U.S. and the rest of world is puzzling. The rest of the world should benefit from a relatively strong U.S. economy and struggling European and Asian economies should create problems for American multinational companies. Perhaps this has not happened because the U.S. dealt with the debt crisis a decade ago more swiftly and aggressively than the rest of the world. Additionally, it could also be the technological disruption caused by the so-called FAANGs (Facebook, Apple, Amazon, Netflix and Google) that are all listed in the U.S. Or perhaps, U.S. markets have overpriced recent tax cuts and underestimated the impact of the current administration’s trade policies.
As long as the labor force is growing and/or workers are becoming more productive, economies, in theory, should keep growing. As we continue to emphasize, this is never a straight, smooth highway, but rather one subject to detours and construction usually not well warned by signs. We would advise against trying to guess at the detours and construction as this will likely not result in any shortcuts and indeed, may prohibit you from arriving at your destination. This is why much of the investment policy we suggest is based on simply staying the course. Specifically, we espouse a policy that insulates your portfolio with approximately nine years of cash and fixed income, which supports remaining funds being allocated to a diversified growth component. It is extremely difficult to get meaningful, inflation-beating growth without risk and this justifies the occasionally bumpy road that equities sometimes take. Over time, we continue to expect well-diversified and managed equities to deliver substantial gains, albeit with some patience required during the trip.
Urban Financial Advisory Corporation – July 2019