Equity train rolls through dysfunction junction without derailing

Brian Nick

The last week’s market highlights:

Quote of the week:

“Time is your friend; impulse is your enemy.” – John Bogle
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2019 Outlook :
  • U.S. economy: A slowdown, not a recession
  • Global economy: Amid lower expectations, emerging markets could surprise to the upside
  • Policy watch: Fewer tailwinds, stronger headwinds
  • Fixed income: Rates likelier to rise than fall  
  • Equities: Late cycle but good value
  • Asset allocation: A neutral stock-bond view

U.S. economy: Ouch

In the past, government shutdowns have been short-lived and left few scars on the economy. This one, already the longest on record, seems unlikely to be resolved anytime soon, as President Trump and Congressional Democrats continue to dig in. Meanwhile, economic data has begun to show the effects of the stalemate.
Case in point: According to Bloomberg, consensus first-quarter GDP forecasts have fallen to 2.2% from a peak of 2.4% in December. The New York Federal Reserve’s outlook has similarly dropped, to 2.1%. Even the White House has acknowledged that the shutdown has had a greater negative impact on the economy than it first anticipated. The president’s chief economic advisor, Kevin Hassett, now believes GDP will register just 1.7% in the period, which would be the economy’s worst quarter since 2016.
There are plenty of reasons to expect slower growth as the impasse drags on. Aside from the fact that some 800,000 people are no longer receiving paychecks, businesses that count federal employees as big customers—think Washington, D.C. restaurants—are suffering. Contracting firms that work with now-shuttered federal agencies have seen their cash flows dry up. And with the Small Business Administration closed, some entrepreneurs awaiting loans have had to halt plans for investment and hiring. Even publicly traded companies are feeling the squeeze. Delta Airlines recently announced that the shutdown will cost the company $25 million in revenue in January alone, as fewer government contractors and employees travel.
Should the shutdown last through the end of the first quarter, U.S. GDP growth could slow by a cumulative 0.5% to 1.0%. (The rule of thumb is that every time federal workers miss their biweekly paycheck, GDP eases by 0.1%.)
The implications of an extended shutdown go beyond GDP forecasts, however. Now that the Federal Reserve is in “wait and see” mode regarding future interest-rate hikes, we think the possibility that the Fed will forego further rate increases will rise dramatically the longer lawmakers and the president remain at loggerheads. Moreover, business and consumer optimism will likely take a hit. Indeed, the University of Michigan’s (preliminary) consumer sentiment index for January dropped to its lowest level in more than two years. Survey respondents cited a host of concerns, including the government shutdown, the impact of tariffs, and the lack of clarity about monetary policy as reasons for their less-upbeat outlook.
On a positive note, the consumer sentiment press release stated that while a decline in optimism is “certainly consistent with a slowdown in the pace of growth, it does not yet indicate the start of a sustained downturn in economic activity.” We agree. Notwithstanding the negative impact of the shutdown, levels of federal spending remain high, and consumers should continue to benefit from last year’s tax cuts. Against that backdrop, we anticipate first-quarter GDP expansion of around 2%. Although this forecast is below our earlier expectation for growth in the 2.5% range, we still believe the U.S. remains poised to do much of the global economy’s heavy lifting.

It “may” be time to rethink Brexit

On January 15, the U.K. Parliament overwhelmingly defeated Prime Minister Theresa May’s Brexit proposal, just 10 weeks before the U.K.’s scheduled departure from the European Union (EU). The deal, had it been approved, would have set rules of the road for important issues like trade, customs, and the “Irish backstop”—the plan to ensure an open border between Northern Ireland, which is part of the U.K., and the Republic of Ireland, a member of the EU.
Despite this crushing defeat, May will live to fight another day. On January 16, she survived a no-confidence vote proposed by opposition leader Jeremy Corbyn. A successful motion would certainly have required her to step down; a prime minister would be expected to do so after losing so soundly on a signature bill, particularly one so painfully negotiated.
What’s next for May? Here are three possibilities:
  • Renegotiate a deal with the EU that will pass Parliament before the March 29 Brexit deadline. We don’t think this will happen given the bill’s wide margin of defeat (432-202). Moreover, the EU is operating from a position of strength and hasn’t expressed a desire to grant any new concessions to help May win parliamentary approval.
  • Allow the U.K. to leave the EU without a deal in place. This “crash out” option, also known as a “hard” Brexit, is unlikely—and unpopular, to boot. It would also be unproductive, in our view. That’s because under such a scenario, the U.K. would probably endure at least a minor recession, with financial contagion potentially spreading to the continent. In addition, the U.K. could face a decline in its currency, the pound sterling, leading to rising inflation.
  • Delay the Brexit date and yield to “the will of the people.” This could take one of two forms: (a) via another “Leave/Remain” public referendum similar to the original, June 2016 version; or (b) by a vote taken after the U.K. and EU renegotiate a deal from scratch. Recent polls show that choice “a,” returning to the ballot box for a do-over, is gaining momentum.     
Financial markets seem to have shrugged off last week’s Brexit headlines. The pound sterling, for example, rebounded from a swift plunge in the immediate wake of the June 15 vote to end the week slightly higher versus the U.S. dollar. U.K. stocks (+0.7% in local terms) got a lift from hopes for a U.S.-China trade breakthrough.
Apparently, in spite of the current state of British politics (which The Economist calls “The Mother of all Messes”), investors reckon that a “softer” Brexit, or no Brexit at all, may ultimately emerge. Over the long run, though, uncertainty of this magnitude is not the market’s cup of tea. That means we probably haven’t seen the last of Brexit-driven bouts of volatility.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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