Trade wars and the Fed
The U.S. manufacturing cycle slowed abruptly at the end of 2018 and remains weak at mid-year 2019. Meanwhile the global manufacturing cycle continued to decelerate through May and is approaching recessionary levels. The 10-year U.S. Treasury yield has traded below the federal funds rate since May 22, and this inversion of the curve is a hallmark of the late cycle. And some of the economic data for the month of May suggested the labour market and the services sectors may now be decelerating, too.
To be clear, we are not in a recession. But the disconcerting dynamics above are causing our quantitative models to send a warning signal about the potential for an economic downturn in the next 12 months.
The Federal Reserve is likely to take these downside risks very seriously. At the end of the first quarter we forecasted the Fed to remain on hold for the bulk of 2019. But with downside risks re-intensifying and with inflationary dynamics weakening, it looks increasingly likely the Fed will now cut interest rates in both July and September. The crux of the argument is that the cost of a precautionary rate cut is now very low. Normally, late in the cycle central bankers are constrained by the prospect of an inflation overshoot. However, core personal consumption expenditures (PCE) inflation is running below 2% and market- and consumer-based inflation expectations have downshifted. Given the Fed wants higher inflation right now, we think it’s more likely the Federal Open Market Committee will cut interest rates to buffer against downside risks.
It remains an open question whether the Fed’s policies will be enough to save the economy and markets from the trade war. What is clear is that we are at a very important fork in the road for markets.
The road more traveled is one of rationalism, where President Trump wants and needs a strong economy in early 2020 to bolster his reelection odds, and he seeks out a trade deal with China to ensure that outcome. In this scenario, we see the Fed cutting rates twice to “un-invert” the curve, the removal of trade policy uncertainty providing a lift to capital expenditures (capex), and Chinese stimulus measures in effect. As a result, we’d expect a positive mini cycle to take hold and drive risk markets higher for the next few years. In addition, 10-year Treasury yields, while initially dampened on Fed cuts, would eventually rise from 2% in late June back up to 2.75 or 3%.
The other road, named “maximum pressure”, is one where President Trump continues his risky strategy of tightening the screws on China through tariffs and other more targeted measures, where the Fed struggles to achieve an accommodative monetary policy stance against so much uncertainty, and global capex tumbles. In this scenario, if the policy mistake is big enough, we possibly could see an economic recession by year-end. With U.S. equity valuations still trading at the expensive range of history, we could be looking at a drawdown of 30% or more. The Fed normally cuts overnight rates by 400-500 basis points (bps) in a recession, and without that policy space, would likely cut these rates to zero, employ forward guidance, and kickstart quantitative easing (QE) again. In this scenario, 10-year U.S. Treasury yields could fall to 1% (or lower).
The future path of trade policy is likely to be a key catalyst for markets, but it’s nearly impossible to predict where it will head with any degree of conviction. This is the dilemma we’re faced with at mid-year. A positive central scenario but with asymmetric risks to the downside.
- Cycle: Neutral to slightly negative. We are late cycle and fading fiscal stimulus is likely to slow the economy relative to its breakneck pace of 2018. The trade war re-escalated in May and this uncertainty is likely to challenge U.S. and global capex. The outlook crucially hinges on what happens with Sino-American trade policy. For now, we assume a downside risk bias given the asymmetry of what a negative outcome could mean for U.S. equities. The warning signals from the yield curve and the Business Cycle Index model are instructive in this regard.
- 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 estimates for the S&P 500 Index remain very unattractive.
- Sentiment: Slightly positive. Our momentum indicators have turned higher with the strong equity market rally thus far in 2019. Our more behavioural, contrarian, indicators suggest the market is neither panicked nor euphoric.
- Conclusion: We maintain a very small underweight preference for U.S. equities in global portfolios, solely on the back of their expensive valuations. Our conviction levels tactically are low.