SECOND QUARTER ECONOMIC OUTLOOK
April 30, 2019
U.S. & World Economy
A tremendous rally in the U.S. and global stock markets thus far into 2019 is supported by signs that central banks worldwide are willing to hold tight on interest rates, bringing the possibility of easing interest rates back into the conversation. In the U.S., the market indexes have topped last year’s record highs despite expectations of the first year over year drop in U.S. corporate earnings since 2016 as macroeconomic headwinds continue to pull down estimates from analysts. U.S. companies are seeing a slowing in both top line growth (demand), as well as higher labor costs, eat into earnings. Upward pressure in wage growth could ultimately spurn corporate earnings growth but in light of the fact that wage growth is so delayed in our recovery, it could also spiral and potentially harm corporate earnings further as corporations fight increased costs with layoffs, especially in light of unresolved tariff negotiations. Global growth estimates have been trimmed by the International Monetary Fund (IMF).
Core inflation in the U.S. remains mild and continues to undershoot the central bank’s 2% target, a target the Fed watches closely and by which it infers the health of our economy. We have a “dovish” Fed, standing on the sidelines understanding that the economy cannot tolerate higher interest rates without stalling out or falling. We also have experienced an inverted yield curve, defined as an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same quality. A yield curve inverts because investors predict the economy (and the stock market) will be weaker at a point in the future than it is now so they buy longer-term debt instruments (pushing down their yields) that outlast their expectations for the duration of a downturn. Recessions last an average of 18-months so if investors believe a recession is likely, they will move their cash from risky equities to Treasuries that will protect their principal for a couple of years while they sit on the sidelines and witness falling equity prices.
Most agree we are in late cycle expansion where high-quality and low risk are increasingly more important investment considerations. Late cycles also have an average duration of 18 months but we would argue in relation to the longest bull market on record, this late cycle could stretch beyond average with the lack of inflationary pressures and the stall out on interest rate hikes. All signs indicate we are approaching a plateau before we roll over to a recession. While in the U.S., wage growth is likely to lead to rising unemployment, tariff impasse continues to impact earnings, an inverted yield curve makes cash more competitive and will likely let the US Dollar drift back down. After peaking at close to 4% in 2017, trade faltered sharply last year yet the outlook for global growth in 2019 is still 3.3%; slowing but still not bleak.
Inverted Yield Curve
The canary in the coal mine
Economists have always had trouble forecasting an upcoming recession. A few get it right; most miss it.
But it’s not as if we lack warning signs.
The Conference Board compiles what is called the Leading Economic Index®, or LEI. It’s akin to Paul Revere’s midnight ride. It has historically warned of an impending recession, but the timing is in question.
There are 10 components of the LEI. These are leading predictors of economic activity:
- Average weekly initial claims for unemployment insurance
- Building permits for homes
- 500 common stocks
- 10-year Treasury bond less federal fund rate (yield curve–more on this in a moment)
- Average weekly hours for manufacturing,
- New orders for consumer goods and materials
- The ISM® Index of New Orders
- New orders for nondefense capital goods ex-aircraft
- Average consumer expectations for business conditions
- Leading Credit Index™
Kink in the curve–inversion
Recall the list of leading indicators. Number 4: the yield curve.
Normally, the yield curve is upward sloping. As the maturity of bonds lengthen, the investor receives a higher yield. Think of it like this: you expect to receive a higher interest rate on a two-year CD than a six-month CD.
But there are times when the yield curve inverts. Shorter-dated bonds yield more than longer-dated bonds.
On March 22, the yield on the three-month T-bill exceed that on the 10-year Treasury by 0.02 percentage points (U.S. Treasury Dept). That hasn’t happened since 2006.
Importance: the last seven recessions (going back to the 1969-70 recession–using NBER data and data from the St. Louis Federal Reserve) have all been preceded by an inversion of the yield curve. We must go back to 1966, when a brief inversion was followed by a steep slowdown in growth and not a recession.
On average, a recession ensued 11 months later.
An inverted curve is signaling that investors believe short-term rates will eventually come down in response to a weaker economy. It may also hamper lending by banks.
But, is it different this time? “It’s different this time” a four-word phrase that should always set off alarm bells. Usually it isn’t. But are we getting confirmation from other signals?
- Another strong recession predictor is an inversion of the 10-year/2-year Treasury. That has not occurred, as the 2-year yield has been falling along with the 10-year.
- The Conference Board’s Leading Index has been flat since October, signaling the slowdown in U.S. growth. But it has not declined.
- In addition, weakness in Europe has pushed yields down sharply overseas (Bloomberg), which may be encouraging some global investors to park money into higher-yielding U.S. bonds.
- The Fed is no longer eyeing rate hikes, and financial conditions have eased during the first quarter.
Recessions have typically been preceded by major economic imbalances, such as a stock market bubble or housing bubble. Or, a sharp rise in inflation forces the Fed to aggressively respond with rate hikes.
For the most part, neither condition is currently present, lessening odds a near-term recession is lurking. Further, recent market action has been impressive. It’s not as if we haven’t seen some volatility, but year-to-date performance isn’t signaling an economic contraction is imminent.
Let me emphasize that it is our job to assist you! If you have any questions or would like to discuss any matters, please feel free to give me or any of my team members a call.
As always, we are honored and humbled that you have given us the opportunity to serve as your financial advisor.
It was hard to remember the feeling of going through a heart attack experience of 4th quarter of 2018. All of the sub asset classes on 1st quarter of 2019 were positive. Equity markets returned over 10% this year, and 1-year return for S&P 500 is 9.5% and MSCI World is 3.23%. Most of the international equities’ return for 1-year were still negative. In the US equities, most of the “growth” and technology-oriented securities were the top of the return ranks.
Global Real Assets class also bounced back strongly except for commodity related securities and still, their returns were reasonable due to a slower global GDP growth forecast. Both Real Estate and Natural Resource equities did well for all three time periods as illustrated in the chart that follows. We are looking to express this segment of the portfolio into more tactically rotating managers who may have the systematic approach to measure change of global growth numbers and the sign of a rising inflation number.
Both Global Fixed Income and Alternatives had very strong consistent return numbers for each of their categories. Non-US fixed income securities are still negative for 1-year time frame. On the other hand, Alternative securities had more positive return numbers for 3-year basis. We are looking for few securities in unconstrained fixed income asset class so that in the late cycles, PMs will be given more flexibility to make tactical bets looking for reasonable returns. Life settlement sub asset class is not listed but, it also had positive return number.
“We make a living by what we get. We make life by what we give.” --Winston S. Churchill
In January, I visited Thailand on a Vision Trip with Plant With Purpose, a non-profit 501(c)3 helping impoverished communities around the world “grow their way out of poverty.” On this trip to Northern Thailand, we visited the hill tribe villages established by refugees from nearby countries where we witnessed the positive effects of the charity as evidenced by the progress made to reverse deforestation and teach economic empowerment. In these villages, PwP has worked alongside the villages for years to teach sustainable agricultural processes and establish VSLA (Village Savings and Loan Associations) leading to healthier people and relationships. While these refugees have extremely meager monetary wealth, they have immense wealth in relationships and faith. The villagers hosted us for presentations and shared meals and we eagerly participated in projects to plant seedlings, build a check dam and clear a firebreak in the steep jungle. While a language barrier prevented verbal communication, working beside someone in the heat and steep terrain builds a relationship that goes beyond words. In my opinion, serving others has greater returns than any investment we will ever come across.
Late cycle investing is still full of opportunity but it is simultaneously marked by decelerating economic growth. Identifying opportunities and risk mitigation through recalibrating diversified asset investing is our passion and expertise. We look forward to discussing our tactical moves in our upcoming quarterly meetings.
Leslie, Matt, Bart, Letitia & Stella