The first half of the year ended on an optimistic note, as the U.S. and China appeared to be making some progress in their trade talks and the Fed is now expected to lower the federal funds rate at the July meeting. The global economic expansion has slowed, but we believe that the risk of a recession in the U.S. remains a low probability. While investors continue to worry about these and other things, the S&P 500 index has continued its upward trend to new highs.
After months of negotiations, China and the U.S. appeared headed for some form of resolution on trade. However, what appeared likely in mid-April began to unravel in May. As a result, the U.S. increased the tariff rate on $200 billion of Chinese goods from 10% to 25% on May 10th. Additionally, President Trump threatened to impose tariffs of 25% on an additional $300 billion of Chinese goods. In retaliation China increased its tariffs on $60 billion of U.S. goods.
In June, the World Bank decreased its 2019 world GDP forecast from 2.9% to 2.6%. Additionally, confidence among trading partners and businesses declined. For example, the Business Roundtable’s second-quarter CEO Economic Outlook Index declined 6%. Despite the fall, their outlook remains at above average levels. This survey reveals expectations for sales as well as plans for capital spending and hiring. Because business confidence leads capital spending, this is a key index to monitor.
The risk of a recession has risen, but conditions that typically precipitate a down-turn are not currently in place. No apparent bubble conditions exist like what occurred with the 2007 housing excesses. Among the metrics we are monitoring are consumer financial health, sentiment and inflation. Currently the consumer is in great shape with record net wealth, manageable debt-to-income, historically low unemployment, and modest wage growth.
U.S. inflation continues to be below the Fed’s 2% target. This fact provides them with flexibility, as needed, to ease monetary policy again in response to the temporary slow-down. The persistence of low rates has resulted from substantial productivity gains that are allowing for higher wages, yet benign overall labor costs. Also, inflationary pressures have been muted by heightened competition and price transparency due to e-commerce and low interest rates and energy costs.
With the global economy slowing, interest rates have moved lower and 3-month yields are now above the 10-year yield. This move in the yield curve and the ongoing trade and tariff disputes have not been overlooked by the Federal Reserve. At the June meeting rates were left unchanged and they now will consider easing again, which puts a July rate cut on the table. Global central banks also began ratcheting up efforts to inject more stimulus into their economies. In June alone seven central banks cut rates and several others suggested they are close to lowering rates as well.
The volatility in the U.S. stock market seen in May was largely driven by tariff-based economic concerns and may arguably increase the administration’s motivation to reach a resolution. There also may be pressure on China to resolve the trade war, as U.S. imports from China have fallen sharply and they are grappling with a slowdown that will see output growth slide to the weakest pace in almost three decades.
What does all this mean for investors? We believe it means the most likely path is more of the same. A mild slowdown within an economic expansion, even one as long as the current ten-year run, provides a constructive background for stocks, although one that likely experiences more volatility. The US economy has experienced three other growth slowdowns during this expansion in 2011, 2013, and 2015 without a recession occurring.
The continual challenge in such a strong market is to find investments that offer an attractive return relative to risk. That is our focus in the analysis of each of the investments held in client accounts. It is important to ensure that the risk exposure is appropriate, to concentrate on fundamentals and be disciplined to look past near-term volatility to achieve long term consistent results that meet our long-term objectives.
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