First Quarter, 2019 Economic and Market Commentary

Highlights: 

· Central banks across the globe have become decidedly more dovish as growth around the world slows. Stocks soared in response to signs that central banks are willing to keep holding interest rates at low levels for the near future. 

 · The U.S. agreed to delay tariffs on Chinese imports in response to what President Trump hailed as substantial progress in trade negotiations with China.  This was also a boon for stocks during the quarter. 

 · Despite strong equity returns to begin the year, anxiety remains high amongst many investors and trading volumes have stalled.  This is likely a byproduct of the Great Recession hangover and a progressively dimmer global economic outlook. 

Commentary:

While recession fears have not entirely receded, the panic that gripped financial markets in late 2018 has subsided for the time being.  That panic was sparked by global central banks dialing back stimulus, as well as proliferating political risks.  While political risks persist, from Britain’s flailing effort to exit from the European Union to ongoing trade negotiations between the U.S. and China, central banks turned more dovish during the quarter.  Specifically, the U.S. Federal Reserve (Fed) signaled a halt to interest-rate increases and flexibility in reducing its bond holdings while the European Central Bank (ECB) indicated it is ready to use all of its policy tools to support Europe’s softening economy.  This includes restarting a bond-buying program, holding interest rates at their current levels and issuing a fresh supply of cheap long-term loans for banks.  Combined with mounting hopes for a U.S./China trade deal, this set off a rally that helped global stocks recoup last year’s losses.

It is not a coincidence that Fed Chairman Powell and President Trump both reversed course on key policy positions in the same week.  Both were responding to mounting evidence that the U.S. economy is slowing.  As of now, central bankers have emphasized a pause on tightening monetary stimulus rather than launching new stimulus.  This would imply a belief that central bankers currently believe that the global economy is slowing down, but not heading toward an outright recession.  Furthermore, negative interest rates in Europe and Japan, combined with still historically low rates in other wealthy countries including the U.S., leave central bankers with little room to cut borrowing costs to provide stimulus if their economies falls into recession.  Thus, recent actions by central bankers seemingly imply more of a pre-emptive strike to prop up weakening growth before any slowdown intensifies and forces central banks to resume buying large amounts of debt or lending money to banks.

Since 2015, the Fed has been normalizing monetary policy by raising interest rates and shrinking its bond holdings from post crisis levels.  Thus, it was significant news when the Fed announced during the quarter that they see no more rate increases this year and they will stop shrinking the balance sheet this September, essentially declaring the normalization process complete as of this time.  There is no denying that stimulus measures enacted since the financial crisis of 2008 have been successful.  The economy has for the most part been growing steadily since 2009, the unemployment rate of 3.8% is just above a 49-year low, and inflation this year, excluding food and energy, is likely to hit its target of 2%.  The surprise is that the Fed feels that maintaining these conditions requires such expansive monetary policy, as the current federal-funds rate at between 2.25% and 2.5% is just a 0.25% real rate when adjusted for long-term expected inflation.  Compare this to a real rate of 2.75% at the end of the Fed’s last tightening cycle in 2006 and 4% at the end of the prior cycle in 2000.

This has led some economists to suggest that underlying forces such as slow-growing populations and diminished investment opportunities continue to weigh on economic growth and inflation around the world. Recent evidence in the U.S. includes signs of moderating consumer spending, the workhorse of the U.S. economy, and dozens of companies recently slashing their profit forecasts for the first quarter in the face of rising wages and energy costs.  Whether these are temporary blips or evidence of a late-cycle economic slowdown, at a minimum, these are big tests for the sustainability of a bull market that is now in its tenth year.

Nevertheless, the U.S. arguably continues to be in better shape than most other countries.  The ECB never managed to raise its interest rate out of negative territory or shrink its balance sheet.  Similarly, the Bank of Japan has shown no sign of raising its target rate from negative territory anytime soon.  Although the Federal Reserve took interest rates close to zero in the aftermath of the financial crisis, it never cut rates below zero. Negative rates are intended to reduce borrowing costs and make it more attractive for companies and households to borrow, spend and invest, as well as boosting exports by weakening an economy’s exchange rate.  On the other hand, negative rates generally curb bank profits because they cannot be fully passed on to customers and raise the risks of housing bubbles by propping up interest-rate sensitive sectors such as real estate.

Although European stocks are off to their best start to a year since 2015, the uncertainty about Brexit and Italy’s unstable government coalition has many investors remaining cautious on Europe’s rebound.  There is also a longer-term concern that the Eurozone will continue to be held back by political discord, a focus on fiscal restraint, and an economy that is sensitive to global trade so that any problems in either the U.S. or China can drag it down. 

Having now rejected Prime Minister Theresa May’s Brexit deal three times, Brexit outcomes that once seemed extreme now seem more likely.  These include another referendum to revoke the exit altogether, a general election, or an exodus from the EU with no trade agreements in place.  EU leaders just recently agreed to postpone Brexit until October 31st to give Prime Minister May more time to try to secure the U.K.’s Parliament approval of a divorce deal with the bloc.

Citing substantial progress in trade negotiations, including key issues such as intellectual property and technology transfer, President Trump agreed to delay increases on Chinese imports that were set to take place during the quarter.  As we saw in the mid-80’s when another fast-rising Asian power, Japan, built up a huge trade surplus with the U.S. and threatened American economic supremacy, setting deadlines and threatening tariffs doesn’t necessarily solve the fundamental problems driving trade imbalances, including America’s propensity to spend money it doesn’t have.

One could argue that these trade imbalances have simply transferred to China.  Perhaps having studied Japan’s experience, China is putting up greater resistance to the concessions that the U.S. wants.  Ultimately, however, China’s economy is likely to take a hit, whether it gives in to U.S demands or resists and suffers a big tariff hit. China’s President Xi Jinping realizes his country faces an economic slowdown, the likes of which it has not seen for almost three decades.  Accordingly, the government lowered its economic growth target this year to between 6% and 6.5% and unveiled a series of stimulus measures.  These included cutting some taxes, reducing the reserve rate for banks, and spending on big infrastructure projects to boost employment.  The debt level has doubled since the global financial crisis ten years ago to around 300% of the gross domestic product of its economy, and the goal of these stimulus measures includes more than just growth.  It also includes stability in managing the pending slowdown and avoidance of exacerbating imbalances in an economy already exposed to too much debt, industrial overcapacity, and unsold homes.  The next several quarters will be a big test for China in determining how far it has come in its transition from state-backed investment to domestic consumption as the main driver of growth.

Current economic conditions might not be as strong as they were a year or two ago, but GDP, employment and earnings growth remain solid.  It is almost impossible these days to turn on the television, browse the internet or read a newspaper and not see or hear some economist or financial expert predicting a doomsday scenario.  As such predictions are constant, it is inevitable that at some point, some will be reasonably correct.  However, on an ongoing basis, such predications are never near accurate enough on which to base investment policy.

Admittedly, investor anxiety remains high and this is evident in frequent and recurring periods of volatility in the equity markets.  This is because the 2007-08 financial crisis is still well within memory and everyone knows the market recovery since then has been straight and long.  However, although the risks of market pull back and recession may be increased, their timing and extent are still quite uncertain.  The favored and suggested investment policy is to concede their inevitable eventuality but remained poised to participate in growth either before or after the occurrence of the event.  Insulating the portfolio with low risk investments as necessary to allow one to identify the capital which can be invested for the longer term will allow the portfolio to whether the volatility but still significantly participate in growth.   

       

Urban Financial Advisory Corporation – April, 2019