The US economy is slowing but is expected to outpace “stall speed”. GDP grew 3.1 per cent last year, its best calendar-year showing since 2005. Economists credit a powerful blend of monetary accommodation and an unprecedented corporate tax cut for this expansion. While lawmakers hoped the incentives would fuel a self-perpetuating investment renaissance, initial indications suggest the legislation simply provided a booster shot. Now, it appears, the medicine is wearing off and the US economy is downshifting toward its longer-term 2 per cent trend growth rate.
Retail sales growth, while positive, slowed to 2.3 per cent year-over-year through January; that’s half the rate reported in October. Similarly, consumer confidence, a good predictor of spending, has slowed. The labor market echoed this trend: employers created a scant 20,000 net new jobs in February, the worst monthly showing since September 2017. This result stands in stark contrast to the average monthly gain of 209,000 jobs over the last 12 months.
Investors are increasingly concerned that the world’s economic problems are beginning to wash up on our shores. China, the world’s second-largest economy, has a larger impact on global growth than does the United States due to its greater pace of expansion, and economists expect China to flirt with deflation this year. China’s growth rate slipped to 6.4 per cent last quarter, representing it slowest annual pace since 1990. We expect 2019 will be a difficult year for China as the country grapples with an export recession and an overhang of debt.
China’s troubles are reverberating in Germany, where manufacturing contracted for a third consecutive month (Exhibit #1). China, Germany’s largest export customer, remains embroiled in a trade dispute with the United States. While investors anticipate a binary outcome – deal, or no deal – the negotiation is in fact much more nuanced, owing to the interconnectedness and complexity of the underlying issues. It’s possible that certain tariffs could remain in place indefinitely. In a relationship in which China to the US more than four times the amount that the US sells to China, it is likely the Chinese economy will remain crippled even if progress is made in the trade talks.
Though growth rates in the US and the rest of the world are converging, we’re not forecasting an imminent US recession. As long as job creation remains on track and wages expand faster than inflation, we believe the likelihood of a US recession over the next four quarters is small.
Global equity markets rebounded from their dismal 2018 finale to stage an impressive 2019 rally, led by US small caps. The Russell 2000 Index rose more than 14.6 per cent during Q1/19. Blue chips, as represented by the S&P 500, gained 13.1 per cent, their best quarterly showing since 1998. International equity markets, helped by toned-down rhetoric from the Federal Reserve, ratcheted higher as well. The US dollar, which was on a tear last year, flat-lined in the first quarter. International developed markets gained 10.2 per cent and emerging markets picked up 9.9 per cent over the period. Underlying some of the equity market enthusiasm, bond substitutes, like real estate investment trusts (REITs) and master limited partnerships (MLPs), stole the show: income equities surged more than 16 per cent in Q1/19 as investors clamored for yield substitutes in the face of sliding bond yields.
Bond investors flexed their risk-taking muscles in Q1/19 as lower credit quality outperformed stellar credits. High-yield bonds surged 7.6 per cent in the first three months of the year, reversing an ugly Q4/18. Emerging market and international bonds also surged, fueled by a backpedaling Fed and a flat dollar. Underneath the credit rally, Treasury rates declined, particularly the 10-year maturity. The benchmark Treasury yield slid 27bps over the quarter thanks to a quiescent Fed and economic slowing. The slide was sharp enough to invert the yield curve, sending a recession signal to nervous investors.
Historically, a sudden interest rate slide typically reflects poor economic fundamentals. This time, however, stocks are rallying. Inflation, a key ingredient in interest rate levels, rose a scant 1.8 per cent, below the Fed’s 2 per cent target. Investors appear to be signaling that they are currently experiencing the best of both worlds: modest growth and low inflation.
To say the stock market is unpredictable, particularly over short time periods, is an understatement. Nowadays, even market trends are apparently trendless: one of Wall Street’s most popular trading strategies, trend following, has failed to deliver as global equity markets confound the quants. The algorithms behind trend following look for market entry and exit points based on years of historical data and relationships. The strategy, which currently accounts for about $220 billion invested, was once regarded as a smart way to protect downside risk. Yet in today’s 24-hour news cycle punctuated by 240-character tweets, particularly from America’s Commander-in-Chief, the models aren’t agile enough to respond to such dynamically changing news and market conditions. Moreover, unprecedented monetary policy, including quantitative easing and negative interest rates, created unique problems for models that rely on historical relationships. Trend following fell woefully behind a simple buy-and-hold approach over the last 10 years, resulting in massive outflows at the end of 2018. This suggests that, while history and human nature tend to repeat themselves, markets and strategies continually evolve.
Despite the central banks’ best efforts, economic growth and inflation appear to be in a secular downtrend. In fact, these secular trends have been in place for decades but were largely masked by Federal Reserve actions. Beginning in 1987 with Chairman Greenspan, the central bank’s stimulus strategy was to spur growth through debt accumulation; every time the economy got the sniffles, Greenspan & Co. would simply lower the borrowing rate. Given that a 30-year mortgage rate was 10.5 per cent at the time, the Fed had a lot of runway. However, America’s borrow-and-spend strategy eventually reached its crescendo when debts had to be repaid, culminating in a financial crisis induced by the collapse of a housing bubble.
Ben Bernanke, Greenspan’s successor, helped pull the US economy out of the mud by knocking overnight borrowing rates to zero and slashing longer-term rates by purchasing nearly $4 trillion of Treasury notes and mortgages. The world’s central banks followed suit and ultimately purchased nearly $15 trillion of bonds and other financial assets to keep interest rates artificially low and to stimulate borrowing.
Ten years later, our current expansion is three quarters shy of surpassing the longest US recovery in modern economic history (Exhibit #2). Our nation’s economy is 22 per cent larger than it was at the depths of the 2008-2009 financial crisis. The S&P 500, enjoying a 10-year bull run (punctuated by pullbacks in 2011, 2015, 2016 and 2018), is more than 400 per cent higher. Remarkably, despite this prosperity interest rates are lower today than they were in March 2009, the low point of the economy and the markets.
Several factors suggest global interest rates, including longer-term Treasuries, are in a new regime. Demographics are one important element. Populations are aging, particularly within the developed world, and retirees tend to rely more heavily on bonds to fund their retirement. As of the end of last year, 16 per cent of the US population is over 65 years old; that’s up from 12.9 per cent 10 years ago. Besides that, the “Alexa Silver” generation accounts for 19.1 per cent of Canada’s population and 22.2 per cent of Germany’s.
Income inequality also plays a part. High income earners tend to save more of their pay, pushing stock prices up and bond yields down. As of 2015, the top 1 per cent of US households took in about 18 per cent of our nation’s adjusted gross income; that’s up about 3 percentage points from 2009, according to the World Wealth and Income Database.
Probably the biggest reason why rates are as low as they are is the actions of the world’s central banks. In 2009, Ben Bernanke’s Federal Reserve embarked on an experimental stimulus program called quantitative easing, whereby the Fed purchased 10-year Treasury notes and mortgage securities in order to keep intermediate rates low and to encourage borrowing. All told, between 2009 and today, the world’s central banks have accumulated a portfolio of $20 trillion of financial assets. While attempts have been made to reduce their balance sheet positions, the heightened sensitivity of the global economy to interest rate changes has prevented their moves to lighten up. All of this suggests that monetary policy, which has undoubtedly shouldered most of the policy burden for the last several decades, has probably run its course. Until interest rates more accurately reflect true economic activity, policymakers must become Keynesians.
Financial Market Strategy
The yield curve is inverted and investors are aflutter because historically, when the 3-month T-Bill yields more than the 10-year Treasury note, recessions aren’t far behind. According to our research, the last five recessions were preceded by yield curve inversions ranging from 12 to 24 months in advance (Exhibit #3).
That said, the yield curve may be sending a distorted signal this time, because of the trillions that the world’s central banks have plowed into 10-year government notes. For that reason, we’re monitoring other metrics, like financial conditions and liquidity levels, for clues that would corroborate the curve inversion.
Though liquidity conditions tightened last year as equity markets sold off, much of that has reversed this year along with the equity market rebound. High-yield bonds, for example, have rallied more than 7 per cent so far this year, a move that seems inconsistent with an economy headed toward recession. The Financial Conditions Index calculated by Bloomberg, which incorporates credit spreads and market volatility, is currently situated in the second quin-tile of its 10-year range, suggesting relatively “easy” conditions (Exhibit #4). While the yield curve has historically been an important, high-profile economic weather vane, we believe it’s too early to head for shelter as long as liquidity conditions remain robust.