The past week’s market highlights:
Quote of the week:
“No growth without assistance. No action without reaction. No desire without restraint.” – Li Mu Bai, Crouching Tiger, Hidden Dragon, 2000.
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Q2 Outlook:
- U.S. economy: Late cycle has arrived.
- Global economy: There’s still good news out there.
- Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
- Fixed income: Bond markets offer few places to run, even fewer places to hide.
- Equities: The bull market’s not over, but expect plenty more volatility.
- Asset allocation: Valuations are no longer at extremes.
U.S. economy (part 1): We’re not terribly concerned about the economic impact of U.S. trade policy
President Trump raised the stakes in the trade tiff with China. On June 18, he threatened a 10% tax on at least $200 billion of Chinese imports if Beijing didn’t abandon its intention to retaliate against his June 15 levy, which targeted $50 billion of imports from industries of strategic importance to China’s economic policy. That earlier tariff is scheduled to take effect on July 6. The latest measure, which will kick in no earlier than the fall, will hit a wide range of products, potentially leading to higher prices for U.S. consumers. China’s government warned of “strong countermeasures.”
Amid a barrage of jarring headlines about a brewing trade war between the world’s two largest economies, market participants are understandably concerned. Last week, large-cap equities stumbled amid the rising trade tensions, with the S&P 500 Index (-0.9%) snapping a four-week winning streak and Europe’s STOXX 600 Index declining 1.1% for the week. In contrast, the Russell 2000 Index (+0.1%)—whose small cap companies are less vulnerable to trade concerns—extended its winning streak to eight weeks.
Our outlook, though, is not so dire.
We believe the current and proposed tariffs, taken together, would trim just 0.1%-0.2% from U.S. GDP growth in 2018. If the U.S. economy were wheezing along—generating just 1% growth, for example—such a reduction would be meaningful. However, we expect the economy to expand by at least 3.5% in the second quarter and by 2.8% for the year as a whole.
Moreover, the tariffs shouldn’t prevent U.S. companies from delivering another quarter of superior earnings. Indeed, a repeat of the first quarter’s 20%+ earnings growth is possible. That’s because firms will once again be comparing profits from a post-Tax Cuts and Jobs Act (TCJA) period to those generated in a pre-TCJA period. Based on the flurry of positive second-quarter economic data, companies should also be able to maintain 8%-10% increases in revenues. Forward guidance will be key, especially relating to decisions on hiring and investment affected by trade or trade uncertainty.
In terms of consumer price inflation, the tariffs’ overall effect is likely to be negligible. Tariffs already in place, such as the one on steel and aluminum imports imposed earlier this year, have lifted production costs for businesses using those metals. But these higher costs, for the most part, haven’t filtered through to consumers. In addition, few of the goods subject to the June 15 tax are consumer items. Lastly, the 10% tariff on $200 billion of Chinese imports—$20 billion—is small relative to the nearly $19 trillion U.S. economy and $1+ trillion in TCJA tax cuts.
U.S. economy (part 2): We’re not overly worried about the flattening yield curve, either
In addition to the bevy of negative articles on global trade, last week the financial press also homed in on the potential dangers associated with a flattening yield curve. The yield on the 2-year Treasury—which tends to rise when investors expect more aggressive Federal Reserve interest-rate policy—closed at 2.56% on June 22. Meanwhile, the 10-year note fell 3 basis points (0.03%) during the week, to 2.90%. This left the gap between the two yields at just 34 basis points, near its narrowest point in more than a decade.
A flattening yield curve sometimes sparks worry that it will actually invert, which takes place when short-term yields exceed long-term yields. Such a phenomenon is rare, often signaling a looming recession.
Here, too, we offer some positive perspective. Obviously, while the yield curve has flattened considerably, it hasn’t inverted. Some curve flattening is normal as the Fed raises interest rates. So based on Treasury market action, it’s premature to fret about an economic slowdown. As we see it, a recession is at least 6-12 months away for the following reasons:
- Inflation, although edging up, remains well contained. If this trend persists, the Federal Reserve will be able to raise interest rates steadily, yet gradually.
- The fed funds rate is still at a level that will stimulate the economy.
- Treasury markets have continued to trade in an orderly fashion. The rise in yields, while abrupt at times—most recently in May—has been gentle over the past few years.
- Despite registering its smallest gain in eight months in May, the Conference Board’s index of leading economic indicators still points to “solid growth,” according to the press release accompanying the data. Unless the index decelerates and turns negative, a recession isn’t likely anytime soon.
To sum up, not only do we believe a recession isn’t imminent, we think the current nine-year run of U.S. growth could last into the next decade. Based on the admittedly scant data available so far, an increase in private capital spending over the past 12 months appears to be contributing to increased worker productivity. In effect, the economy could be creating more capacity for growth. This should ease concerns about a shrinking pool of available workers and a resulting sharp rise in wage inflation. A more productive workforce could also allow the U.S. to expand at a faster pace than it has, on average, since 2009, meaning interest rates can rise further without harming growth.