Highlights:
· In response to weak inflation, the U.S. Federal Reserve cut short-term rates by a total of 50 points during the quarter in an effort to maintain the current U.S. economic expansion.
· Outgoing European Central Bank president Mario Draghi set the groundwork for a long period of ultra loose monetary policy for his successor, Christine Lagarde, and emphasized that fiscal policy should be a priority in the future.
· China’s economy continues to grow at a slow pace, but has adopted a stability-first strategy rather than the all-in stimulus approach taken in the past at the first sign of decelerating growth.
· The UK economy is performing below its potential due to Brexit uncertainty, but the Bank of England believes that the UK banking system is resilient to the financial impact of a worst-case disorderly Brexit.
Commentary:
Powell speaks. Trump tweets. China reacts. Markets freak. Repeat. (Credit: Bloomberg Businessweek)
It seems increasingly common that equity prices are reacting mainly to the words of three men – Donald Trump (typically via his Twitter account), U.S. Federal Reserve Chairman Jerome Powell and president of China Xi Jinping – while Europe is caught in the crossfire due to its heavy reliance on exports. Nevertheless, stocks generally continue to benefit from an environment characterized by low economic growth, low inflation and low interest rates. Looking beyond the volatile market backdrop, the U.S. economy remains resilient with a healthy labor market that is consistent with where we are in the economic cycle. This is characterized by cooling employment growth, a rising labor force participation rate and modest wage growth. The unemployment rate currently sits at 3.5%, which is the lowest rate in the last 50 years.
Similar to this time last year, the U.S. and China remain caught up in a trade war that looks unlikely to end anytime soon. This time, however, the manufacturing malaise that showed signs of spreading in Europe and Asia in late 2018 has started to materialize in the U.S., with the U.S. manufacturing industry shrinking for the first time in three years. Global growth continues to show signs of slowing and U.S. inflation has failed to convincingly reach the Fed’s 2% target since formal adoption in in 2012. With all this in mind, Fed Chairman Powell reduced short-term interest rates by 0.50% during the quarter, via cuts of 0.25% in both July and September. These rate cuts negated half of the rate increase the Fed imposed in 2018, with an additional 0.25% cut still forecast by the end of the year. When the fed was raising rates from near zero over the past few years, it was done to proactively keep price pressures in check and prevent asset bubbles from forming. Now Fed officials are worried that inflation pressures are too weak, not too strong. Even though lower rates leave the Fed less flexibility to cut them in the future, if and when economic growth slows, Fed officials are fighting harder to raise inflation now, while the economy is good. This “mid-cycle adjustment” is intended to avoid inadvertently killing the current U.S. economic expansion. In Mr. Powell’s words, “We’ve seen it in Japan. We are now seeing it in Europe. That road is hard to get off.” This was also seen in the U.S. in 1937, when that economic recovery was cut short by a sudden tightening of monetary and fiscal policies, which slashed gross domestic product by 10%.
Fed policy decisions influence not only the U.S. economy, but the rest of the world as well. If the Fed gets it wrong and the U.S. enters in to a recession, it will buy less goods from abroad than it would have if growth had been maintained. The Eurozone’s wobbling economy is particularly sensitive to dwindling global trade flows because it is heavily reliant on trade for growth. In response to trade tensions, the European Central Bank (ECB) laid the groundwork for a long period of ultra loose monetary policy by cutting its key interest rate and launching a sweeping package of bond purchases. These actions by departing ECB president Mario Draghi commit his successor, Christine Lagarde, to negative interest rates and an open-ended bond-buying program for the foreseeable future. With interest rates at historical lows, and below zero percent in much of the world, Draghi believes monetary policy will have a difficult time continuing to guide and sustain the world’s advanced economies as it has for the past several decades. Draghi believes that fiscal policy – government spending and taxing decisions – are likely to take on greater importance in the future. France apparently took note of Draghi’s comments, recently unveiling billions in new tax cuts for both individuals and businesses.
The Bank of England might also need to consider relaxing credit conditions due to Brexit uncertainty that caused the UK economy to shrink for the first time since 2012. The UK economy had grown earlier in the year after manufacturers’ stockpiling in anticipation of Brexit helped to boost production output. The Bank recently commented that the UK economy was performing below its potential due to high levels of uncertainty surrounding the UK’s departure from the European Union and did not rule out future interest rate cuts, which have been on hold at 0.75% since August 2018, when they were raised from 0.5%. The Bank also recently expressed confidence that the UK banking system is resilient to the financial impact of a worst-case disorderly Brexit. This is due to UK banks being forced to hold back more capital, and demonstrate access to £1 trillion in liquidity, which would allow the banking system to continue to lend into the economy even if the UK were shut out of international markets for up to three months.
Japan is an example of a country that has likely gone as far as it can in cutting interest rates and purchasing government bonds. After nearly three decades with the world’s lowest interest rates, which have failed to end its near economic stagnation and deflation, Japan is now facing weak world trade and a slowing Chinese economy. With other central banks like the Federal Reserve and ECB cutting interest rates, it is likely to put upward pressure on the yen, which would reduce the value of foreign earnings for Japanese companies and potentially affect the country’s exports. Nevertheless, Japan recently increased its consumption (sales) tax for the first time in five years to fund social welfare programs and pay down its huge public debt load. Previous sales tax increases have resulted in consumer spending dropping off sharply, but this time around the hit is expected to be more modest due to a comparatively strong economy and rebates for certain purchases made using electronic payments.
Chinese policymakers have already taken steps to stimulate its economy with fiscal measures, including tax and fee cuts. Unfortunately, to date, this has not stopped growth from slowing to a pace not seen since the early 1990s as businesses hold back on making big investments in the face of trade tensions with the U.S. This led China’s central bank to recently step in and release approximately $126 billion into the financial system by reducing the amount of reserves that commercial banks are required to keep with the central bank, as well as lowering the reserve ratio for smaller banks to enhance financing support for small and private firms. These looser credit conditions are an attempt to increase business and consumer spending, and to keep the economy growing by the 6-6.5% target set by China’s leaders. Even with this latest round of stimulus, China is the only one of the world’s three largest economies not currently slamming its foot on the growth pedal. In past cycles, any hint that lofty growth forecasts were under threat led to all-in stimulus, but this time around, President Xi Jinping has adopted a stability-first strategy. Even though the world’s second largest economy continues to struggle with sluggish global demand and hefty debt levels, China seems to be willing to sacrifice short-term growth to avoid long-term damage to its economy.
We realize it is difficult not to pay attention to the day-to-day movements of the equity markets, especially when the market is at all time highs and volatility spikes in response to frightening headlines touting many of the issues discussed above. However, an investment policy based on attempting to consistently time when business and market cycles will begin or end, economies will recess or grow, or politics will be favorable or unfavorable for investors, has a low probability of long-term success. Rather, we believe investors should be committed to an investment policy that concedes the inherent volatility and unpredictability of the equity markets. This is achieved through insulation of the portfolio with cash and fixed income exposure representing portfolio withdrawals for several years and maintains well managed and strategically diversified equity exposure to provide a means of growth over most long-term market cycles. Investors cannot control the markets’ day-to-day movements, but they can maintain control of their portfolios by committing to a prudent investment policy that takes a long-term view and avoids having to make timing decisions that will likely derail returns. As Mark Twain said many years ago and which still hold true today:
“October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”
Urban Financial Advisory Corporation – October 2019