Summer 2019: Economy & Markets
July 25, 2019
Given its longevity and the fragility of the global economy, concerns abound over the expansion’s durability. There is little indication, however, of an impending downturn. U.S. GDP was off to a solid start in the first half of 2019, paced by a robust 3.1% annualized advance in Q11 and moderate growth of just over 2% likely for Q2. Our full year forecast, for GDP to increase in a range of 2% - 2.5%, is intact2.
We continue to expect that growth will be consumer led. While consumer spending was disappointing in the first quarter, it rebounded nicely in April and May. Between the government shutdown earlier in the year and the trade war, consumer confidence has been volatile but continues to hold healthy levels and understandably so. The unemployment rate and jobless claims are hovering near 50 year lows. Job growth has been accompanied by steady, if unspectacular, wage gains. The recently announced trade war truce between the U.S. and China will hopefully provide a further confidence boost.
The industrial side of the economy has been more lackluster. Capital spending accelerated after the passage of tax reform and then tailed off. Exporters may be reluctant to invest amid all the uncertainty over tariffs and a truce rather than an actual peace agreement may be insufficient. The ISM (Purchasing Managers) Manufacturing Index has fallen close to a three-year low but is still in expansion territory3.
Employment growth has slowed a bit in 2019 but remains well above levels needed to absorb new entrants to the labor force. It is well known that there are more job openings than there are available workers. We suspect that some of the softness in job creation is related to a shortage of skilled workers rather than a retrenchment by employers. It is surprising that wage growth is only a moderate 3.1%, retreating from 3.4% six months ago4.
We have been wondering for nearly two years when a flagging supply of workers would impact the economy. According to the Bureau of Labor Statistics, the labor force shrunk slightly during the first six months of 2019. Given the aging population and declining (legal) immigration, it is unclear if many folks are left to come off the sidelines to fill job openings. From an economic point of view, U.S. demographics are not encouraging and no longer terribly different from the rest of the developed world, which at some point will be an impediment to growth. For now, job growth continues its unprecedented run.
A more hopeful sign for the economy is that productivity in the first quarter hit a 9-year high of 2.4%. Productivity is key to generating sustainable economic growth and rising per capita income. It has been mired closer to 1% for some time, leading many economists to reduce their long term run rate for the economy below 2%. It is entirely possible that this upsurge is merely a result of better cyclical growth and temporary in nature. However, should rising productivity prove durable due to improving technology or other factors, it would provide the basis for an upgrade to the underlying trend of the economy.
Tariffs aside, a weaker global economy remains a cause for concern. We are hard pressed to name a major economy that will grow faster in 2019 than in 2018. Europe seems to be floundering yet again and has few viable policy options to revive growth. China also continues to slow and even the current 10% tariffs on many of its products will shift manufacturing elsewhere, but the government is willing and able to add both monetary and fiscal stimulus to counteract a slowdown.
The U.S. is relatively insulated from slowing global growth but not immune. On the policy front fiscal stimulus will also ebb. On the bright side, the Federal Reserve has announced its intent to support and preserve the expansion. As such, we expect the Fed to cut the Fed Funds rate as soon as the end of July. Bond yields have been declining all year and the yield on the 10-year Treasury has plummeted 69 bp to a mere 2.0% as of June 305. Mortgage rates have fallen in turn. This has breathed life into a moribund housing sector.
It is often noted that expansions do not die of old age and this one should survive into 2020 and, perhaps, beyond. After all, Australia’s current expansion is approaching three decades in length. In the post-war period, recessions have been attributed to three sources. Overly restrictive monetary policy has been cited as the major cause through the 1990’s, while the recessions of 2000 and 2007 were the result of bursting financial bubbles. The oil embargo of 1973 also spawned a downturn.
None of these conditions appear on the horizon. Federal Reserve easing is imminent. Never has the Fed cut rates when the economy in the prior month added over 200,000 jobs but there is always a first time. While asset prices are elevated, we do not believe they are divorced from reality as in 2000 and 2007. Furthermore, our banking system is currently much healthier, and credit is widely available and inexpensive. Finally, the boom in U.S. energy production has obviated concern over an oil shock.
Financial markets were certainly heartened by the Fed’s dovish turn in the first half of the year. Returns for major equity markets, domestic and international, were uniformly in double digits. The U.S. remained the standout as the S&P 500 Index rallied 18.5%. The bond market as measured by the Bloomberg Barclays Aggregate Index advanced 6.1%, while oil and gold improbably surged as well. High yield bonds gained an equity-like 9.9%. Investors struggled to explain this “everything rally” and reconcile how equity investors and bond investors could simultaneously be so bullish.
After hiking rates like clockwork every quarter in 2018 and suggesting that they could well do the same in 2019, the Fed took additional rate hikes off the table in January and now a rate cut or even two seems probable in 2019. While the U.S. economy is running at or near full employment, inflation is well below the Fed’s 2% target as it has been for most of the past decade and it is difficult to argue that lower rates will cause any short-term harm to the economy. Presently short-term Treasury bills yield more than the 10-year Treasury note5. An inversion of the yield curve is commonly considered an indicator of overly tight monetary policy and a harbinger of recession. The Fed will likely try to eliminate this condition.
We recently lowered our target for the yield on the 10-year Treasury to a range of 2.0% - 2.5% from 2.50% - 3.0%2. Negative bond yields prevail throughout much of the developed world and will continue to place a ceiling on yields here at home. Furthermore, the Federal Reserve will shortly curtail reduction of its balance sheet and eliminate a source of supply of U.S. government debt to the market. Absent an improvement in the global economy, we may be forced to lower our target range yet again.
The S&P 500 Index is hovering at record levels and now trades at a Price/Earnings multiple of 18x 2019 earnings, the top end of our valuation range. Earnings growth is likely to be tepid this year and increase by at most 5%. We remain cognizant that current policies concerning trade, immigration, and, even, easy money may be desirable politically in the short term but could pose risks to economic growth in the long run. Therefore, we cannot argue in favor of increasing equity exposure. Nonetheless, with interest rates in decline and near historic lows and little sign of imminent recession, we are cautiously optimistic. A few years ago, the acronym “TINA” was in vogue, an abbreviation for “there is no alternative” to equities. We seem to have returned to that state for the time being.
Sources: (1) U.S. Bureau of Economic Analysis (BEA); (2) Washington Trust Wealth Management; (3) Institute for Supply Management (ISM); (4) U.S. Bureau of Labor Statistics; and (5) Factset Data Service
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