The close of second quarter 2019 marked the 10-year anniversary of the end of the Great Recession. This officially makes this economic cycle the longest continuous expansion in U.S. history, surpassing the previous economic upswing that lasted from March 1991 to March 2001. This reality leads many prognosticators to worry that the aged economic cycle is nearing its expiration date. But as we have been saying for some time, we don’t believe the mere passage of time is a useful indicator of a looming recession. Rather, we believe recessions occur because something is in excess economically and needs to be recessed. Right now, excesses appear minimal, and the Federal Reserve (Fed), whose rate hikes have historically served to help push “excess-ridden” economies over the edge, has no desire to tighten the U.S. into a recession.
Notwithstanding this analysis, the second quarter of 2019 saw economic growth weaken, which once again led a chorus of naysayers to bang their recession drums loudly. We note that most of the weakening has been on the manufacturing side, while the consumer and services side of the U.S. and global economy has remained steady. We continue to believe that this points the finger firmly at uncertainty emanating from the U.S.-China trade war as the primary culprit of the global economic wobbling. Interestingly, the equity market fallout has been, in our estimation, largely limited because the Fed and other central banks have pivoted to dovish stances.
As we look to the future, investors must channel their inner Justin Bieber and ask themselves, “Is it too late now to say sorry?” More specifically: Did the Federal Reserve tighten so much last year that no matter what they do this year, the recession writing is already on the wall? Secondly, are the U.S. and China capable of finding a trade war solution after one side eventually says they are sorry?
The Federal Reserve Is Ready to Act Upon Its Words
The biggest question for markets is whether the Fed’s apology has come too late since monetary policy impacts the economy with a 12- to 18-month delay. Put differently, did the Fed tighten so much in 2018 that an economic recession is approaching no matter what the Fed does today? Our answer to this question remains a resounding no. We view this in a very simplistic manner; only when the real cost of money (real rates) becomes more expensive than the real opportunity of borrowing it (real economic growth of GDP) is a recession likely to ensue. Current U.S. real rates (Federal Funds rate less inflation) is somewhere around 0.50 percent to 0.75 percent. This compares to real potential U.S. economic growth of 1.8 percent to 2.5 percent. Real rates do not appear to be restrictive.
And we believe that the Fed will not be timid in its apology for previous rate hikes and will back it up with rate cuts in the coming months. Quite simply, in our estimation the Fed cannot risk having a recession occur before it sustainably meets its 2 percent inflation target. Fed decision makers spent the past few years staking their credibility to meeting this goal, and if they don’t meet it, they must be asking themselves, what that means about their future operating strategy.
During the quarter, inflation stayed below the Fed’s 2 percent target. While we agree with their assessment that this is a temporary (transitory) phenomenon linked to an inventory buildup after the fourth quarter market decline, we still believe they will act by cutting rates. In his June post-meeting press conference, Fed Chair Jerome Powell made two key comments:
1. We need to be strong on inflation and don’t want to be seen as weak on inflation, and
2. an ounce of prevention is worth a pound of cure.
Both these comments lead us to believe that a rate cut is in the works.
We have long operated with the belief that the Fed has shifted from its historical role of fighting inflation to one of enhancing inflation and economic growth. Indeed, the Fed has adopted a new overarching goal or operating framework of “sustaining the economic expansion.” This is a complete shift from its previous goal of moderating business cycles. We also note the Fed now “listens to the market” even when the market’s forecast differs from theirs. With the market pricing in multiple rate cuts, the Fed will not want to risk disappointing like it did in fourth quarter 2018.
In our view, unless you believe the Fed has tightened too much already or don’t think its apology is sincere, economic bears are going to need to find another reason for a recession to ensue. We believe the Fed plays a critical role in determining the end of economic cycles; right now our analysis leads us to believe they have no desire to end this one, and it still has ample ammunition to impact future economic growth. Given the lack of economic excesses coupled with our Fed analysis, we don’t think a recession is likely in the near term. However, we worry that further intensification of the trade war between the U.S. and China could increase the risk of a recession.
Are the U.S. and China Capable of Saying Sorry?
During the quarter, the U.S.-China trade war re-escalated. After investors were led to believe that a deal may be only weeks away, on May 5, the president sent an angry tweet in which he accused China of breaking prior promises and responded by increasing the tariffs on China from 10 percent to 25 percent effective June 1. China responded in kind, which led the U.S. to further up the ante by barring U.S. tech companies from doing business with Chinese tech giant Huawei.
After a lull in talks – complete with finger pointing and harsh words – President Xi and President Trump once again met on the sidelines of the G-20 meeting on June 28. The outcome was positive, with:
1. negotiations re-opened;
2. the U.S. holding off on further increasing tariffs on $300 billion more of goods;
3. U.S. companies being allowed to do business with Huawei.
Many opine that neither side is willing to say sorry, and a deal will be elusive. We continue to disagree and believe that the president wants to get a deal done and will not push for a GREAT deal if it risks pushing the economy and markets into the abyss. Indeed, we believe that if the president desires re-election, he needs a rising stock market and economy to take to the voters in 2020. This trumps any trade deal, and the president knows this; perhaps that is why he tweets about the rising market and the economy so often.
Let us offer this potential timeline for a U.S. and China deal. The U.S. administration has not fought simultaneous tariff wars on multiple fronts, likely to keep uncertainty manageable. Indeed, only after the United States Mexico Canada Agreement (USMCA) deal was near completion did the administration focus its lens and up the tariff ante on China. During the second quarter of 2019, the administration suspended potential auto tariffs on Europe for six months until November 2019. We would place this as an informal deadline to wrap up the China trade deal. Then, perhaps, the administration will train its eyes on Europe and attempt to close that deal in time to take a “Promises Kept” theme to the 2020 election.
While foreign economies have been harmed by the trade war more than the U.S., we note that during second quarter, leading economic indicators in China and other Asian economies moved higher. Eurozone Composite Purchasing Managers Indices (PMI) have steadied and moved higher as countries, such as France, recovered from the disruptive Yellow Vest protest. This has undoubtedly been helped by global central banks easing policy as they ponder what a recession would mean if it occurred while their government bonds sport negative yields. The bottom line is that we don’t believe that the administration has yet pushed so hard that the globe falls into a recession, and we don’t believe that it is Trump’s goal to push so hard for an apology that the U.S. and global economy tip into the abyss.
Will Investors Be Sorry?
Our analysis continues to point to rising economic growth, which we believe will ultimately support a rising stock market. Indeed, our outlook has remained extremely consistent over the past few years and equity markets have pushed to record levels. However, the path to higher markets has become volatile. From the depths of despair during the fourth quarter market plunge that was perversely accompanied by strong economic data, to the rip-roaring returns so far in 2019 that have pushed equity markets to all-time highs while economic data has weakened, equity investors have been strapped to an emotional roller coaster. Not only have equity returns been robust, but fixed income returns have also been strong as bond prices rose on the back of falling yields. This confusing stew creates a fertile backdrop for emotional investors to react wrongly.
Our recommendation remains steadfast: Investors should build a long-term portfolio guided by a financial plan. Indeed, it’s always prudent to review your portfolio and make sure each asset is tied to a specific goal, and after rallies like we experienced it’s a great time to conduct such a review rather than wait until the next time the market falls and panic ensues. And while it’s tempting to rid your portfolio of underperforming asset classes, one must resist the urge to eliminate diversification. Building portfolios is not about trying to place all your chips on the asset you think will provide the best return, but rather building in hedges against unforeseen risks.
Once again, U.S. interest rates have pushed nearer to or below the Fed’s intermediate- to long-term inflation target. The 10-year U.S. Treasury closed the quarter at a yield of 2 percent, exactly at the Fed’s inflation target. Given that we believe inflation is still economically feasible and now deemed socially desirable by the Fed and policymakers, we think the opportunity to earn real returns in fixed income has headwinds – that’s not to say fixed income is a bad investment, however.
If our analysis is incorrect and the U.S. economy doesn’t reach 2 percent inflation and a recession ensues, even at low yields bonds will provide real returns and, importantly, a hedge against likely falling equities. And shorter-term bonds and cash are necessities to provide reliable income streams for those needing money in the near to intermediate term.
On the other side of the equation, one must ponder what happens if inflation rises and bond yields eventually follow suit. Under this scenario stocks will likely be impacted since they have rallied partially because of low interest rates. This is where we still think commodities may provide a portfolio hedge since they are positively correlated with inflation. We realize that this asset class has suffered lackluster returns over the past few years because inflation has remained low, but low inflation is why bond returns have remained positive during this time even with low starting yields. In other words, diversification has worked.
The temptation to abandon diversification grows as economic cycles age, volatility grows and investors pile into asset classes that have worked recently while abandoning those that don’t have a recent track record of good performance. In our time of navigating markets, these actions almost always end with investors having to say they are sorry.