Let's Make a Deal
The U.S. economy continues to show signs of strong, if slowing, momentum.
The Fed has clearly signaled a pause in rate hikes.
The jump in hiring is being attributed to the massive corporate tax cut that went into effect this past year.
Helping to keep price pressures low is the slump in oil prices.
The eurozone has had a significant decrease in the pace of economic growth in the past year or so.
"Clowns to the left of me,
Jokers to the right, here I am,
Stuck in the middle with you."
All things considered, concerns about the global economy’s prospects appear overblown. While growth has weakened and become more divergent around the world, it remains above potential in many developed economies, and emerging markets still appear in the early stages of recovery with room to run.
However, we are in a period of high political uncertainty both at home and abroad. From continuing trade tensions to Brexit to talks of a looming U.S. fiscal hangover and the path of future Fed rate hikes, the list of policy risks is not short and remains the biggest threat to the global economic outlook.
The U.S. economy in particular continues to show signs of strong, if slowing, momentum. Although the personal impact from the recent government shutdown on federal workers and contractors should not be overlooked, the impact on the overall U.S. economy is likely minimal. The CBO estimates the shutdown will shave just 0.4% off real GDP growth in Q1. The bigger concern is that the recent impasse may serve as a prelude for further budget fights in months ahead over reinstating the debt ceiling and lifting budget caps. In particular, failure to do the latter will cause a large step-down in government outlays, which have been adding roughly half a percentage point to GDP growth over the past year.
Of course, governmental dysfunction is not just a problem here at home. Overseas, ongoing political divisions in the European Union and its member states are threatening the stability of the EU’s institutions. Brexit negotiations are on the front burner, but they constitute just one political risk contributing to the region’s weaker economic outlook. From Italy’s fiscal squabbles to turmoil in the streets of France, increasing political fragmentation and lack of consensus on the future of the eurozone has limited policymakers’ abilities to enact much-needed reform.
Meanwhile, trade tensions are now running over a year old and are beginning to have scarring impacts on global investment decisions and sentiment. Although the latest round of talks between the U.S. and China have been encouraging, we have been here before and a positive outcome is far from certain. The U.S. administration also remains unhappy about trade imbalances with partners such as Europe and Japan and is keeping the threat of auto tariffs in play. Should President Trump follow through with action, it would likely prove more damaging to U.S. and global growth than all other tariffs, given the sector’s global integration.
For now, the U.S. economy has shown remarkable resilience in the face of all these headwinds. January’s 304,000 increase in nonfarm payrolls, for example, was the largest in nearly a year and continues a long-running trend of 100 consecutive months of job gains. Despite increasingly dour predictions from economists concerned that the ten years of uninterrupted growth must soon come to an end, most macroeconomic indicators remain solid. But job gains are a lagging indicator, and more timely measures of economic performance are pointing to a moderation in growth ahead.
Indeed, the euphoria that characterized business and consumer confidence as recently as October has given way to a more measured optimism. The small business optimism index fell for the fourth consecutive month in January amid rising economic and trade uncertainty, with capital spending intentions sinking to the lowest level since Nov. 2016. A similar pullback was seen in the latest Duke CFO survey, where worst-case projections are for a capital spending drop in 2019, accompanied by flat hiring. U.S. consumers are also growing more cautious. While households’ assessments of their present conditions still look relatively high even with recent declines, the gap between current sentiment and future expectations has hit a near-record low.
The risk here is that a natural slowing of the economy, combined with drags of fading fiscal stimulus, tighter monetary policy, and slower growth overseas, is more vulnerable to a meaningful deterioration in confidence. In that sense, negative sentiment can become a self-fulfilling prophecy if it extensively pervades decisions by consumers or business leaders to invest, spend, and hire. None of this is to cavalierly dismiss sincerely held policy divisions among government officials. Coming to a consensus or reaching compromises is not easy. But until they are, record levels of partisanship and growing political divisions will continue to cast a cloud over the outlook, leaving the rest of us stuck in the middle.
Equity markets have regained their footing in the first two months of 2019, with the S&P 500 up 18.4% from December lows. Last year, we believed that market expectations fell faster than the economic backdrop suggested. Since then, a dovish turn by the Fed and a resumption of trade negotiations with China have improved investor sentiment, while earnings and company guidance released so far have been better than feared. Although the damage from the recent correction has not been fully repaired—the market is still close to 5% below last year’s high—the pendulum of sentiment appears to have swung back to a more balanced position.
Over the recent market decline, we believed markets were reacting to new economic and political realities, and that expectations for global growth and corporate profits were being recalibrated. Our rigorous investment process led us to stay the course over this normal weighing process and not overreact. As we have seen several times before in this cycle, markets eventually reconnect to positive fundamentals. Nevertheless, the recovery has been somewhat surprising in its speed and strength. We remain, as a result, hesitant to signal the “all clear” and continue to believe the correction process may last several months.
Although we do not expect markets to retest recent lows, some type of consolidation or another pullback would be normal. Late-expansion investing has been historically associated with positive stock and bond returns—and has frequently rewarded risk taking. However, this phase of the business cycle has also traditionally come with higher volatility. Market conditions can change quickly as investors adjust to slower growth and greater uncertainty. We expect more upward swings in asset prices when fundamentals improve, as has been the case recently, and downward swings when uncertainty dominates market sentiment, as was the case in December.
In 2018, the biggest source of market volatility was concern that the Fed would increase short-term rates too quickly and, in doing so, derail economic growth. The Fed has come full circle from just three months ago. Officials still expect a strong economy in 2019; however, slowing global growth, decelerating inflation, and unresolved policy issues have all eroded the central bank’s conviction in that baseline somewhat. While this more dovish turn has been cheered by markets and is a near-term positive for risk assets, it is likely premature to suggest that the current tightening cycle is over.
In fact, it can be argued the Fed’s new “wait-and-see” approach on setting interest rates and reducing its balance sheet sets the stage for more uncertainty down the road. We continue to believe that monetary policy remains far from tight and arguably still modestly accommodative. If the labor market continues to tighten and additional wage growth takes hold, concerns that the Fed has positioned itself behind the curve could cause another rise in investor anxiety over the direction of monetary policy.
Trade tensions and global growth also remain a top concern for us. The consensus on the street is that deals will be concluded with China, auto tariffs, and Brexit. We are not quite as confident and believe it will likely be several more months before we have better clarity. In the meantime, slower economic growth driven by uncertainty over these issues could hurt sales and profitability and also provides a headwind to PE’s.
Given this, we think the pace of recent market gains is unlikely to continue and that stocks will grind higher from here more in line with modest corporate profit growth. Financial asset valuations are less compelling now than they were in late 2018. At current levels, the market seems to be pricing in a reasonable balance between present risks and opportunities. However, to warrant higher valuation multiples, we’ll need to see resolution on a number of policy fronts, particularly trade.
Navigating through 2019 will be no easy task. Still, we view the early-year rebound as encouraging. It indicates that a wider investor focus that includes ongoing political risks as well as still favorable fundamentals is an environment in which the stocks can perform reasonably well. Fundamentals are what move markets—over the long term. While this won’t prevent ongoing market volatility, it should allow the long-running bull market to continue over the foreseeable future.
It is clear that the Fed has pivoted to a more dovish stance. As one analyst stated, the Federal Open Market Committee (FOMC) has delivered a market-friendly dovish blast with both barrels of the shotgun: dovish on rates and dovish on the balance sheet. The Fed clearly signaled a pause in rate hikes, saying it can be “patient” in adjusting its strategy. The federal funds rate was left unchanged at 2.375% at their January meeting, which was universally expected. In the press conference following the meeting, Federal Reserve Chairman Jerome Powell argued that the case for rate hikes has “weakened somewhat” in recent months because inflation remains subdued and the risks posed by financial imbalances have receded. With regard to its strategy of allowing assets to run off their balance sheet, the Fed appears willing to end that soon. The Fed wants to maintain a much larger balance sheet than it had prior to the financial crisis. Back then, the balance sheet was almost $900 billion in size. With quantitative easing, the Fed grew it to $4.5 trillion, and with the strategy to reduce the size of the balance sheet, it is now down to around $4 trillion.
This shift, along with the common belief that economic growth will be slower this year, has the markets believing the Fed will not be able to meet its projection of two rate hikes this year. The federal funds futures market currently expects no rate hikes from the Fed this year (see Figure 4).
Following three years of decreasing rate of growth in payrolls, hiring increased by 2.7 million new jobs in 2018 (see Figure 5). This marks the third-strongest gain in the post-financial-crisis era. Based upon past expansions, once payrolls start a downward trend, they tend to stay on that trajectory until a recession ensues. This increase is rare. The jump is being attributed to the massive corporate tax cut that went into effect this past year. Many businesses had their tax liability drop from 35% down to just 21%. This gave them great savings, which was turned around into available funds for additional hiring. With the improving economy, they rightly projected that demand would pick up.
The gains are continuing into this year. Payrolls jumped 304,000 in January, the biggest increase since last February. It was well above the 2018 average gain of 223,000.
The unemployment rate moved up to 4.0%, from 3.9%. It still remains very low by historical standards. The rate increased for good reason as more people entered the workforce and they get counted while they are looking for work.
Domestic price pressures continue to remain muted. Since 2000, inflation has averaged just 1.6% and the current level is 1.9%. Both are below the 2.0% target level, which the Fed initiated in 2012 (see Figure 6). Although tightening labor markets have started to put upward pressure on wages, that extra wealth has yet to find its way into higher prices. Helping to keep price pressures low is the slump in oil prices (down 29% since the recent high in October 2018), which is expected to act as a significant drag for the coming months.
This is not just a domestic phenomenon. Global prices are also remaining subdued with inflation below most advanced countries’ central bank’s target level (which are also around 2.0%). Here, the slowing level of economic growth outside the U.S. has been helping to keep inflation low. Also helping to keep inflation low is the expectation that inflation will stay low, which is due to the low level of inflation for the past two decades.
The eurozone, an economic block of 19 nations, has had a significant decrease in the pace of economic growth in the past year or so (see Figure 7). The yearly change in GDP stands at 1.2%, down from a peak of 2.8% in the previous year. This rate of 1.2% is about half the rate of growth in the United States for the same period of time. However, Q4 data was affected by some technical reasons. Many euro countries are very reliant on foreign trade to drive economic growth. With the slow-down in global trade, this is affecting the economic output. This can be seen in two of the eurozone’s larger economies: Germany has not had positive growth for two consecutive quarters, and Italy has had negative growth in two consecutive quar-ters. It is important to note that the slower pace of growth appears to be just that, a slowdown, not a collapse in economic growth. This is based upon improvement in the labor market. The unemployment rate stands at 7.9%, the lowest level in about a decade. More importantly, wage growth has been relatively strong at 2.5% and inflation has been stubbornly low at 1.6%, giving workers growing purchasing power.