The global business cycle has been on a weakening trend for over a year. Chinese deleveraging, European politics and trade-policy uncertainty all played contributing roles. The U.S. economy, which was resilient to this malaise for the first 11 months of 2018, slowed abruptly in late December with regional manufacturing surveys and the Institute for Supply Management’s manufacturing index respectively logging their largest one-month decline since 2008. New orders and CEO confidence were crumbling at the start of 2019 on the back of tariffs, policy uncertainty and lackluster foreign demand. Left unchecked, a recession was possible. But in many ways this weakness sowed the seeds for a big policy response that should actually help extend the expansion — not forever, but the second-longest U.S. expansion on record lives to die another day 1.
Three important policy responses have reduced the left tail risk for the U.S. economy:
- China: Alex Cousley writes in our Asia Pacific section that Chinese stimulus is ramping up in a way that is likely to stabilise economic growth there at/above 6% in 2019. Weak foreign demand has been a major factor behind the downgrade cycle for earnings estimates of large U.S. multinationals. We think Chinese policy stimulus should help stabilise earnings growth for the S&P 500 Index at around 5% in 2019.
- Trump: The U.S. aggressively pursued tariffs and other punitive measures against China over much of 2018 in an effort to extract concessions. But late in the year, with U.S. markets and business confidence sagging, President Donald Trump reversed course and now regularly professes confidence in his negotiators’ progress toward a deal. Politics aside, this step away from brinksmanship is a positive for corporate fundamentals and markets. We expect a trade deal will be announced in the second quarter of 2019, although the exact contours of that deal and the durability of any agreement remain hard to forecast with any degree of confidence.
- Powell: With the stress in financial markets, the slowdown in global growth, and importantly the U.S. economy’s participation in that slowdown in late December, Federal Reserve Chair Jerome Powell abruptly shifted course, stressing a much more patient approach to monetary policy. Powell’s thesis is that with core inflation failing to threaten the central bank’s 2% target, the Federal Open Market Committee can be patient to wait and see how the economy evolves in the coming months. This was a big change. Previously the Fed seemed happy to hike rates simply on an expectation that a strong economy and a tight labour market would gradually lift inflation over time. Now, Powell is requiring evidence that the actual inflation data accelerates before he is willing to hike rates beyond neutral. That’s particularly important because in the subsequent months, our tracking data for core PCE2 inflation has actually downshifted from a 2% run rate to 1.8% as of mid-March. With this “miss”, we think the current Fed pause can prove durable even in the early phase of a global growth recovery. That’s a tailwind for markets. We do think that the Fed will eventually come back to the table and hike once more this year. But we’ve pushed our baseline timing on that to December from September. A restrictive Fed and yield curve inversions are hallmark early warning signs for the end of an expansion. While we previously thought an inversion was possible in the first quarter of 2019, that now looks like a late 2019 story. With the normal lead times, this pushes our best thinking on the likeliest timing of the next recession out by six to nine months (into late 2020, or even 2021).
The U.S. economy looks like it is responding to Chinese stimulus, the Trump pivot and the Powell pause. There is tentative evidence that lower mortgage rates are stabilising the housing market. And our high-frequency trackers of consumer and business confidence show early signs of an inflection higher in February, as reflected in the chart below. Meanwhile, U.S. consumer fundamentals continue to look robust, as declining unemployment rates and accelerating wage inflation buoy household income.
- Business cycle: Neutral to slightly positive. We are late cycle, and fading fiscal stimulus is likely to slow the economy relative to its breakneck pace from 2018. But with the Fed pause and a healthier outlook for global growth, we think the U.S. economy can deliver above-trend economic growth this year. We now forecast S&P 500 earnings-per-share growth of 5% in 2019, which is roughly on par with the consensus view of bottom-up equity analysts.
- Valuation: Expensive. The year-to-date rally has pushed U.S. equity market valuations significantly higher. Assuming a mean reversion (lower) in corporate profit margins over the next 10 years, our risk premium estimates3 for the S&P 500 Index remain very unattractive.
- Sentiment: Neutral. Our momentum signals lack direction as the tug-of-war from the sharp Q4 sell-off and the sharp Q1 rally works its way through the data. The market which looked panicked at the end of 2018 now looks neither panicked nor euphoric.
- Conclusion: We maintain a small underweight preference for U.S. equities in global portfolios, solely on the back of their expensive valuations.
1This analogy refers to the 2002 James Bond film, Die Another Day.
2PCE refers to personal consumption expenditure inflation, which is a measure of the change in prices of goods and services purchased by consumers throughout the economy.
3Risk premium is the expected return on equities relative to cash or another safe asset like government bonds.