Market Updates

The fourth wave of cyclical upswing in this record-long U.S. economic expansion has been delayed by prolonged policy uncertainties, including (1) an overly “patient” Federal Reserve; (2) three years of Brexit indecision, and (3) an extended trade negotiation between China and the U.S. As these factors head toward resolution, the global economy and risk markets are starting to sniff out the resulting turn in global economic momentum, causing economically-sensitive stocks to recently outperform.

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The deflationary shock that excessive Federal Reserve tightening delivered to the global economy in 2018 continues to spread and deepen, causing the dollar to strengthen, commodity prices to weaken, breakeven inflation rates to plunge well below central-bank targets, and global interest rates to sink to new all-time lows. It’s very important, in our view, that the U.S. central bank get more assertive about hitting its inflation target.

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Despite a strong labor market, elevated consumer confidence, weaker global manufacturing and trade growth, negative tariff-related sentiment, and an inverted yield curve, we continue to believe that a recession is not baked in the cake and can still be averted. While we are not surprised to see a rising risk of recession, we believe the Fed can do more to avoid one. Recent calls for the Fed to paradoxically subvert its own policy goals for political reasons in the name of “independence” undermine confidence in a favorable outcome.

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From Europe to China and India, the repudiation of diesel engines and push for electric vehicles, along with expanding car-sharing availability, are challenging carmakers’ business models and disrupting economic activity. Increased stress in these major car markets over the past year has caused global vehicle production to fall at the fastest pace since the financial crisis, an important factor behind weakening global manufacturing output, energy/commodities demand and international trade.

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Global equities have been on a roller coaster ride in the past 12 months, and the U.S. has outperformed Europe, Japan and the emerging markets. The two big macro questions confronting investors are: 1) can the U.S. and China arrive at a trade deal or ceasefire as the calendar flips to the 2020 election season? And 2) can the Federal Reserve (Fed) and other major central banks cut rates fast enough to thwart the negative impact from trade uncertainty? Our check on fundamentals such as earnings, valuations and sentiment leads us to maintain our preference for U.S. large caps and caution on international equities.

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The lagged effects of the Federal Reserve’s aggressive rate hiking in 2016-2018 continue to put downward pressure on economic growth and future inflation. The slow reversal of this restrictive monetary policy, as reflected in the muted July 31 Fed response to waning growth and inflation trends, has disappointed investors, causing a tightening of financial conditions and deeper inversion of the yield curve.

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Recent fears that the record longevity of the U.S. economic expansion makes a recession more likely have caused many investors to move into cash and other defensive assets. A look at the factors that generally warn of impending recession suggests that these fears may be overblown. The main exception is Federal Reserve policy, which remains restrictive by our time-tested gauges despite the first rate cut in over a decade.

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Following strong global oil-demand growth and an OPEC-engineered inventory decline in 2017, fears of persistently tight oil-market conditions caused oil prices to increasingly exceed our expectations as 2018 progressed, reaching $86 per barrel by early October 2018. However, the price surge proved temporary. Higher-than-expected U.S. supply and a six-month waiver program for eight Iranian oil importing countries caused prices to collapse to $50 per barrel by December and gravitate around $65 per barrel since. In our view, prices are likely to remain moderate despite the expiration of the Iran-oil waivers in May and escalating geopolitical tensions related to the Iran sanctions.

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From U.S.-China trade negotiations to central bank meetings and Brexit, there are a number of events coming down the pike that could shake up financial markets. With a weakening growth backdrop and stubbornly low inflation, global monetary easing has shifted into high gear, with many central banks now signaling more accommodative policy. Here we outline some of the major catalysts for investors to watch as we enter the back half of 2019.

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While markets continue to be distracted by trade tensions, the deflationary shock the Federal Reserve inflicted on the global economy in 2018 continues to work its way through global cash flows. Inflation and inflation expectations are falling around the world, while businesses report declining pricing power and revenue growth. Signs of weakening consumer-income growth are the last step on the road to recession. These are all signs of overly-tight monetary policy.

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Since the Great Depression and WWII, the federal government’s role in promoting certain economic goals has become increasingly formalized through legislative mandates. While Federal Reserve policy has always been focused on the goal of price stability, the specific meaning of price stability has been refined over the years from a general and non-specified, vague concept to the current very specific quantitative definition of a 2% long-run average. We describe the evolution and rationale for the Fed’s more specific target.

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U.S. growth remains strong, yet inflation and inflation expectations are falling rapidly. Global growth is shifting away from the rest of the world and back to the U.S. This relative outperformance of domestic versus international growth is apparent in the latest U.S. business survey data. As interest rates have come down, small-business confidence has risen to a new high for the year, with rising plans for capital spending and more optimism that “now is a good time to expand.”

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Market commentary has been focused on Federal Reserve and trade policy. Evidence has continued to accumulate supporting the view that tighter monetary policy is the dominant force behind the global slowdown rather than the fears of a trade war. Falling inflation around the world is one of the main signs that policy is too tight. This contradicts the view that tariffs are causing higher inflation.

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More economists are starting to acknowledge the rising trend in U.S. productivity growth. We agree with Cornerstone Macro research, who has been among the first to sniff out the end of secular stagnation and call the new stronger productivity trend “the story of the decade." Accelerating productivity growth raises the potential growth rate of the economy. The big rise in productivity growth has caught Federal Reserve policymakers by surprise, causing them to overtighten in 2018. To get inflation up to target, the Fed will need to ease.

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Trade tensions have combined with excessive Fed tightening to further invert the yield curve in recent weeks. While inversions are often a signal of impending recession, they can also be a sign of disinflationary pressure. Either way, in current circumstances, the inverted yield curve implies the Fed has passed neutral and begun to slow down the economy and reduce inflation. This is causing inflation to fall further below the target. The inverted yield curve reflects the reduced outlook for nominal growth in a tighter monetary policy environment.

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