The current US economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle.
The current US economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle. The risks to growth are more daunting outside the US. Italy is struggling to contain borrowing costs, a dark cloud hangs over the Brexit negotiations – the pantomime without any jokes – and China and most other emerging markets have seen growth slow meaningfully. The US, however, is a relatively closed economy, as it is not as dependent on trade as most other countries. Its financial system is also reasonably resilient, thanks to the capital its banks have raised over the past decade.
Despite the above, it was movement in the US equity and credit markets that led to some of the worst returns for stocks since 1931, along with new issues in the corporate high yield bond market, prompting a dry-up in the fourth quarter. Why? Uncertainty, driven by the Federal Reserve (Fed) and President Trump’s Trade War with China. Central Banks remove liquidity from the economy during every late-cycle period, and the current tightening by the Fed seems normal within that context. Bull markets, however, don’t usually end when the Fed removes liquidity. Rather, they end when the Fed removes too much liquidity from the economy, which is what markets are fearing when it views the combination of US interest rates rising and the Fed shrinking the size of its balance-sheet, which is a form of additional monetary tightening.
When we see an inverted yield curve (short-term interest rates higher than long-term ones), it has historically been a reliable signal that the Fed has removed too much liquidity from the economy. Short-term interest rates move above longer-term rates, as the markets begin to assess that future growth will be considerably slower than near-term economic growth. An inverted curve itself contributes to a slowdown as it stymies lending, because the short-term cost of deposits become greater than the long-term return from making loans. However, it should be noted that the US yield curve’s lead-time for a bear market is, on average, 17 months after the inversion occurs.
The self anointed “Tariff Man” in The White House has set a deadline of 01 March 2019, before slapping a further tax on $250billion worth of Chinese imports. These tariffs will be felt by US consumers directly, which was not the case previously as tariffs hit industry and farming. However, after Trump shared dinner à deux with China’s President Xi (at the G20 meeting in Bueno Aires), talks that started in early January could go some way to producing if not a broad based trade deal, then a nominal deal that allows for the removal of the pre-existing tariffs and the threat of a full blown Trade War. Despite the US interest rate increases seen in 2018, the number one worry of investors in surveys for the past year has been trade.
Fundamentals, primarily earnings and liquidity, seem to be following their normal late-cycle paths. Sentiment still appears unusually scarred and wary. None of these factors would suggest the levels of volatility that have appeared in markets. It is much more likely that market volatility is increasing, because household and corporate planning has become nearly impossible in a highly capricious political environment in the US. At the end of the quarter, J.P. Morgan indicated that equity markets seem to be pricing in at a 60% chance of a typical US recession. Looking across asset classes, firstly, US corporate bond spreads reflect a 55% chance of a US recession and secondly, the recent performance of industrial metals imply the commodity markets are pricing in a 56% chance of a typical US recession. The outlier is US high yield credit (or junk bonds issued by companies with higher risks of defaulting), which is pricing in only a 12% chance of US recession. It can be argued, therefore, that a lot of the risk of recession is priced into risk assets.
Looking towards Europe, growth is decelerating across the board – French streets are blocked each weekend, Italian interest rates are prohibitively high, the shock of a Hard Brexit is a real threat for European industry, agriculture and the service sector, and Deutsche Bank is on the ropes. Yet, at this moment the European Central Bank (ECB) has chosen to halt net new bond purchases. Like the US, Europe is now likely to have a more expansive fiscal policy with a Central Bank that sounds less keen on funding Governments. Although it is probable, the first increase in ECB rates has been priced out of 2019 and an active Bank of England (soft Brexit outcome aside) seems improbable too.
While the December survey data shows continued downward momentum, two recent developments should promote an end to this deceleration phase before mid-year. Firstly, we believe a combination of supportive and flexible policy actions, notably China easing and a Fed pause, will combine with a moderation of geopolitical concerns to break the negative feedback loop. Secondly, we look for corporations that have generated robust profit gains over the past eight quarters, to take only limited steps to cut back spending and hiring in the face of slower revenue growth. Against this backdrop, there is a strong case for global consumption gains to accelerate this quarter, as declines in energy prices and global food price inflation boost household purchasing power.