Equity markets rebounded strongly in the first quarter, even as economic growth has slowed, when it became apparent that the Fed would not continue to raise interest rates in 2019. In addition, investors have increasingly come to believe that progress is being made in the trade negotiations with China.
In October the Fed’s view of the economy was such that another five or six rate hikes were still necessary to get to its neutral stance, where threats of inflation and deflation are equally matched. The Fed started backing away from this stance in December and by March they had completely reversed their view. The outlook on the economy moved from a “solid pace of growth” to a view that the recent indicators pointed to “slower growth” in both household spending and business investment. More recent comments include a tolerance of core inflation rates up to 2.5% before possible tightening, a level we haven’t experienced in the last 20 years.
As for the trade dispute, the US and China have been negotiating a new trade agreement for nearly a year now. Tariffs on nearly $300 billion in goods have been postponed as negotiations progressed. Yet current tariffs continue to impact the Chinese as well as the global economy. As a result, there is growing incentive for both the US and China to reach an agreement. Negotiations seem to have made considerable progress and current expectations are that an agreement can be formalized during the second quarter. While the impact of a new trade deal appears to be largely priced into the capital markets, finalizing a trade deal should still provide a positive catalyst for business confidence and corporate earnings growth. However, the market may be disappointed in an agreement that only provides loose promises by China to purchase more US goods.
Due in part to the uncertainties around trade issues, the pace of growth around the world has been declining modestly with global GDP expectations moving from 3.0% to 2.9% for 2019. Europe has seen a significant slowdown in the manufacturing sector, China’s economy has been slowing and there is a Brexit-related slowdown in the UK. US earnings may decline in the first quarter compared to the extremely strong results from last year which benefited from the reduction in corporate income tax rates. US GDP growth in 2019 is expected to slow to around 2%.
In response to economic weakness, policymakers around the world are exploring ways to increase growth, including tax cuts and increased government spending. On the monetary side, central banks are more dovish, and not just our Federal Reserve. China has been especially aggressive from both a fiscal and monetary perspective.
The combination of slower growth, accommodative central bank policy, and lower inflation expectations led to a very flat yield curve, where money market and short term bond yields are equal to, if not higher than, intermediate and longer term bond yields. Historically, an inverted yield curve has foreshadowed a recession, although it is not an infallible indicator and the timing of the next recession is uncertain. However, we must pay heed to this warning from the bond market that the Fed may have gone too far and put this long standing economic expansion in danger.
Interestingly, even if we see the classic yield curve inversion, meaning the 10-year Treasury note falls below the 2-year note, it is not necessarily a bear signal for the stock market. In most cases the market continued to move higher, sometimes significantly, between inversions and an eventual recession. This 2-to-10 year inversion has yet to take place this cycle.
The current business cycle is a decade old and we see little evidence of it coming to an end. We are witnessing historically low levels of unemployment along with higher wages. Increased capital spending, rising productivity and a steady stream of workers re-entering the work force have kept labor costs under control. Consumer finances are strong, the major banks are healthy and business lending is increasing. After a brief pause, growth rates seem likely to improve and for now interest rates and inflation remain low, providing a positive backdrop for financial markets.
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