The last week’s market highlights:
Quote of the week:
"I really think it is not a desirable thing for a president to comment so explicitly on Fed policy." – Janet Yellen
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Q4 Outlook:
- U.S. economy: Still running ahead of its peers.
- Global economy: Trade a bigger concern outside the U.S.
- Policy watch: Trade risks haven’t bitten the U.S. yet, but that may change.
- Fixed income: Continue to position for rising rates.
- Equities: The price is right outside the U.S.
- Asset allocation: Finding pockets of opportunity.
Global economy: What happens in China may not stay in China
"If China's economy was to slow down...they're a big enough economy, it would have spillover effects to the United States," Boston Fed President Eric Rosengren said recently. Let’s take that statement one step further. A steep downturn in China—the single largest contributor to global growth since the financial crisis in 2008—would have spillover effects to the rest of the world.
On Friday, October 19, China reported year-over-year GDP growth of 6.5% in the third quarter, its slowest pace of expansion since 2009. Based on recent data releases leading up to the GDP report, this slightly-below-forecast result didn’t surprise us. The Caixin China General Services Purchasing Managers’ Index (PMI), a gauge of manufacturing and service-sector activity, registered 52.1 in September, little changed from August but far below its most recent peak in January. (Readings above 50 indicate expansion.) While service-sector performance improved, manufacturing output continued to slump amid stalling new-order growth and falling employment.
It’s tempting to conclude that tariffs have been the main culprit behind this GDP/manufacturing deceleration. Although tariffs have played a role, China’s economy had already been slowing well before the U.S. fired the first shot in the nascent trade war. A main driver of the drop has been Beijing’s rollout of regulations to limit the spread of China’s so-called “shadow banking” system. This term refers to activities—such as issuing speculative loans—that financial companies outside the formal banking sector market as wealth management products.
Many of these risky, “off-balance-sheet” loans are used to fund infrastructure projects, a major pillar of the Chinese economy. At the same time, shadow banking assets, which reached a peak of 87% of China’s GDP at the end of 2016, stood at a still-elevated 73% as of June 2018, according to Moody’s. A wave of defaults could potentially devastate the country’s banks and economy, not to mention the global economy. That’s the dilemma facing Chinese President Xi Jinping. He knows the current level of borrowing is unsustainable. He also knows that vanquishing shadow banking would almost certainly derail China’s economy—just as the U.S. would likely have been dragged into recession well before it was in 2008 had the government cracked down on low-quality mortgage-lending.
Mr. Xi faces another, perhaps more daunting, challenge. China is attempting to trim its mountain of debt while stimulating the economy through monetary and fiscal stimulus. In all likelihood, even more stimulus may be needed to assuage skittish markets. After third-quarter GDP was released on Friday, China’s top four economic officials, projecting confidence in the country’s outlook, took the highly unusual step of issuing a statement calling for investors to remain calm. This statement helped China’s Shanghai Composite Index reverse losses from earlier in the day in what’s been a poor year for Chinese stocks. (The Shanghai Composite has fallen more than 20% in 2018 to date.)
U.S. economy: The president learns that you can’t always get what you want
Although President Trump is happy about the economy’s performance, he’s not pleased with the Federal Reserve. Last week, he complained that, in the absence of strong inflation, the Fed is raising interest rates too quickly. We doubt that minutes from the Fed’s September meeting, released on October 17 will quell his criticism.
Chair Jerome Powell and his colleagues expressed confidence in the U.S. economy, noting that gains in employment, personal income, and households’ net worth were likely to support near-term consumer spending. Against that positive backdrop, they signaled that “further, gradual” increases are in store. Moreover, the Fed suggested that it may temporarily boost interest rates above expected long-term levels in order to keep the economy from overheating.
Indeed, last week’s data releases provided additional evidence of economic momentum: They included:
- While retail sales ticked up just 0.1% in September, the retail sales control group, which is used to calculate GDP, jumped a healthy 0.5% and 5% year-over-year. (This group excludes sales of automobiles, gasoline, and construction materials.)
- Industrial production, a gauge of output from the manufacturing, mining, and utilities sectors, rose in September for the fourth straight month.
- The Conference Board’s index of leading economic indicators (LEI) increased in September for the 12th consecutive month. According to the press release accompanying the data, LEI point to U.S. GDP expanding by 3.5% in the second half of the year. We’re not quite that bullish, forecasting economic growth of about 3% over that time frame.
- The number of job openings hit a record 7.1 million, according to the August JOLTS report. With fewer than 6 million people unemployed, there are more jobs available than there are workers to fill them. Also, nearly 3.6 million people quit their jobs in August—just below July’s all-time peak—indicating worker confidence in finding new positions.
On the down side, housing starts, existing home sales, and building permits (an indicator of future housing production) all declined in September. Nonetheless, homebuilders remain confident. The NAHB sentiment index edged up in October, in line with levels reached over the past six months. Although builders expressed concern about the number of unfilled construction jobs, they’re optimistic about demand, which has been fueled by the growing economy and strong labor market.