In November, U.S. and foreign stocks, as well as core U.S. bonds, moved higher. The outcome of the U.S. midterm elections provided helpful clarity about control of both houses of Congress. November concluded with a provisional agreement between the U.K. and the E.U. over the terms of Brexit, which must now pass the House of Commons. This development was positive and welcome, but its passage is still uncertain. In many ways, the notable fluidity of Brexit reflects a similar fluidity of other geopolitical matters on investors’ minds, including the trade dispute between China and the U.S., Italy’s budget dispute with the EU, and OPEC crude production policy, to name a few. Still, the U.S. economy remains strong, with a Q3 growth rate of 3.5%. In the U.S. inflation remained contained, and that, along with the slower pace of GDP growth (Q2’s rate was 4.2%), has helped to ease worries about an overly aggressive Federal Reserve. The Fed, however, is still widely expected to raise its key benchmark rate again in December. In this issue of Insights, we (1) focus on these emerging dynamics in the U.S. economy and Fed policy and (2) provide a preview of our 2019 investment outlook, which we will detail next month.
Following a painful October, many asset classes bounced back in November, as you can see in the table below.
The S&P 500 rose 2.04% on the month, and the tech-heavy NASDAQ moved up 0.49%. The Russell 2000 Index of small companies appreciated 1.59%. The MSCI ACWI Index Ex-USA index, which is a measure of all stocks outside the U.S., rose 0.95%. The MSCI Emerging Market Index was the best performing asset class in November, posting a strong 4.12% gain for the month. Year-to-date through November, however, U.S. stocks moved further into positive territory (S&P +5.11%), whereas both of those foreign stock indices are now down more than 10%.
The Bloomberg Barclays U.S. Aggregate Bond Index rose 0.60% primarily due to lower interest rates caused by softening cyclical sectors and a precipitous drop in oil, which in turn led to lower inflation expectations. For the year through November, the core taxable bond index has returned -1.79%.
Economic data in the U.S. remains broadly solid. The unemployment rate remains below 4.0% and at a level consistent with full employment. Core PCE inflation (personal consumption expenditure), which is the Fed’s preferred metric, remains subdued at approximately 1.8%, below the Fed’s long-term target of 2.0%. China posted a Q3 GDP growth rate of 6.5%, in line with expectations. Its pace of continued economic growth remains largely stable but bears watching. Euro-area growth for Q3, quarter-over-quarter annualized growth rate was 0.8%, slowing from earlier in the year but still positive.
We think that certain problems, such as Italy’s budget dispute with the EU, will remain largely isolated. The actual outcome and terms of Brexit remain extremely uncertain, but so far over the last two years the unresolved fate of Brexit has not lastingly roiled markets. Trade policy worries still overshadow the financial picture, and Europe still faces certain structural challenges. In our view, however, the broad investment outlook remains on balance largely stable. The global expansion is likely to continue over the near future with the United States and China, despite their trade squabbles and slight decelerating pace of expansion, as its growth engines.
Likely Policy Path of the Federal Reserve
We see three key reasons why Chairman Powell and the FOMC may decide to pause rate hikes in 2019. These reasons include (1) global growth deceleration, including weakness in Europe, (2) stable but not runaway inflation or wage growth, and (3) the lack of risks of financial imbalance amid weakness in cyclical sectors.
First, economic growth in the Euro area is decelerating due to both structural and ongoing political challenges, and U.S. growth is set to decelerate further as tax cut benefits fade. Decelerating global economic conditions adversely affect U.S. companies. It can also decrease inflationary pressures, which the Fed monitors closely and is mandated to keep contained through its policy decisions if necessary, primarily by setting higher target interest rates. If inflation is contained, higher rates may not be necessary. Moreover, continued quarterly rate hikes would likely further strengthen the dollar, which in turn can weaken the global competitiveness of U.S. companies and could further damage the stability of emerging markets.
Second, the U.S. is experiencing steady wage growth, but higher earnings are not flowing through to overall inflation. Average hourly earnings in the U.S. just topped 3% for the first time this cycle (chart below on the left). This data point supports the case for the FOMC to continue with quarterly rate hikes; however, the unemployment rate is already at a 50-year low 3.7% (“full employment”), and overall inflation remains stuck in the 2% range (chart below on the right). (The Fed’s dual mandate is to promote effectively (1) price stability and (2) full employment.) In theory, higher wage growth should flow through to core inflation, but the “Amazon effect” and other technological factors have kept a lid on prices.
Third, risks of financial imbalance are lacking amid simultaneous weakness in cyclical sectors. The FOMC tries to strike a balance between raising interest rates too quickly, which would shorten the economic cycle, and too slowly, which risks runaway inflation or other financial imbalances (e.g., housing in 2006-2007). Cyclical industries such as housing and auto sales have begun to show weakness in 2018. The chart to the left shows U.S. existing home sales, and the right shows traffic of prospective home buyers. Both seemed to have peaked in 2017, coinciding with the acceleration of the rate hike cycle. The Fed may not wish to risk prompting additional deceleration as an effect of aggressive tightening in 2019 and so may wish to take stock of the evolving situation by pausing.
We do not currently see any systemic problems in the economy from the standpoint of financial imbalances. There is some weakness in cyclical industries. High levels of corporate debt have increasingly attracted attention, but those corporate debt levels do not currently pose a systemic threat in our opinion. Chairman Powell mentioned corporate non-financial debt in his speech on 11/28, noting that “the area posed little systemic risk,” and concluded that broader, overall risks to financial stability were “moderate.” Taken together, we think that the Fed will pause its quarterly rate-hiking program at some point in 2019.
Preview of 2019 Investment Outlook
In Sage’s 2019 Investment Outlook that will be distributed in January, we will detail our views on the global stock and bond markets. In this preview we outline our general views on the U.S., developed international, and emerging markets.
There is now a more decidedly higher interest rate environment than a year ago, weakening economic data out of Europe, and a wider range of policy and market outcomes from global trade and tariff policy (particularly U.S./China). We still do not anticipate a recession to begin in the next 12 months, but the risks are rising. Financial markets may begin to experience some turbulence before an economic recession occurs.
At the end of 2017, the best way to describe the global macroeconomic backdrop was “Synchronized Global Growth.” Fast-forward a year and the world is still growing, but many major countries are seeing decelerating growth. The chart below shows the Organization for Economic Cooperation and Development’s (OECD) estimates for calendar year GDP growth by region.
In the U.S., cyclical industries have shown signs of weakness due to higher rates (e.g., housing, automobiles, semiconductors). Overall, the global economy remains strong, although there are increasing divergences. In the U.S., consumer and business spending remain strong in general, but we expect modest deceleration in GDP growth in 2019 when compared to this year’s above-trend results. U.S. markets have been resilient in the face of geopolitical noise, but they began to price in additional risk in October, which eased a bit in November. The U.S. and China still have a lot of details to work out in the current trade negotiations despite the apparent “truce” discussed between President Trump and General Secretary Xi at the recent G20 summit. Despite some weaknesses, consumer sentiment remains at cycle highs (chart below), and consumer spending makes up more than two-thirds of the U.S. economy.
Europe’s GDP growth and corporate earnings likely peaked in 2017, and political uncertainty remains high (e.g., Brexit, Italy, OPEC oil production policy). Leading economic indicators have turned weaker in recent months, including certain measures of production (e.g., see below for Germany’s Manufacturing PMI; above 50 signifies growth), which have been decelerating since January of this year.
China’s growth continues to decelerate, and its economy is still making the transition to a service-based economy in a moderate fashion, but the ongoing trade war has raised uncertainty about potentially “faster deceleration,” and that worry has hit its stock market. Emerging market (EM) fundamentals still are on the whole, despite pockets of trouble such as Venezuela, relatively sound. The GDP growth differential remains wide between emerging markets (EM) and developed markets (chart on the left below). Further, as shown below, overall foreign currencies have been stabilizing after the precipitous drop from April through September. Higher growth and stable currencies should be tailwinds for emerging markets in 2019.
Summary and Conclusion
All told, domestic economic growth seems durable if decelerating, inflation remains low, and employment remains high. The U.S. economy is likely to continue to grow but at a slower pace than it has recently, as fiscal stimulus slows and the cost of borrowing rises. There are some specific areas of the economy that are negatively affected by higher rates, such as housing and autos, and those industries have started to show some weakness. Consumer sentiment, however, remains at cycle highs, and consumer spending represents 67% of the U.S. economic output. We are watching closely various economic indicators, including aspects of the Treasury yield curve and signals in the bond markets; however, we continue to foresee a relatively low near-term risk of recession in the U.S. in view of strong corporate earnings, solid manufacturing activity, and positive consumer sentiment.
We remain generally positive on the global economic outlook despite ongoing trade concerns and uncertainties in Europe, including the nature of Brexit and other forms of populism (e.g., the Italy/E.U. budget dispute, Spain’s anti-E.U. sentiment, and OPEC production uncertainty). We were heartened to see the announcement of a temporary trade truce between China and the U.S., but what that precisely means and how much constructive breathing room it will provide remain to be seen. Currently, the details of the truce remain vague, and it has been hard to reconcile some political statements on both sides. We remain of the opinion that in time China and the U.S. will strike a trade deal, but the path to that point remains murky and likely filled with ups and downs. In our view, going into 2019 investors should remain balanced in their asset allocations and avoid overemphasis of one or two investments relative to others. The end of the year is an especially opportune time to review asset allocations for any excess risk exposures and market conditions for any particular opportunities. We appreciate, once again, the privilege of helping our clients on both of these fronts in 2018 and beyond as we look ahead to 2019.
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