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We see a number of factors shaping the current economic and investment landscape, some of which may appear contradictory at first glance.

Jul 2019
Julianna Donovan

Slowing economic growth, rising stock indices and falling bond yields.

We are watching these three major dynamics as we pass through the first half of the year. We see a number of factors shaping the current economic and investment landscape, some of which may appear contradictory
at first glance. For example, why are stock prices rising when the economy is slowing down? Here are the factors that matter most, from our point of view:

While global economic growth is slowing, the U.S. remains comparatively stronger versus other developed countries.

Our estimate is that U.S. growth will slow from a peak of 3.2% annualized in the first quarter to closer to 1% in the second and third quarters, leading to roughly 2% annualized growth for the full year. Keep in mind that while 2% growth may seem paltry, it is on top of the stimulus-induced 3% economic growth we saw in 2018 and exceeds what we are seeing in other parts of the world. Outside the U.S., major economies that are more dependent on exports for economic growth, like Germany and China, are struggling as global trade volumes fell year over year for the first time since the financial crisis. The weak spots are in manufacturing activity and rising inventory levels, which have been affected by global trade issues. In the first quarter companies stockpiled inventory in anticipation of higher tariffs on imported goods. This effectively pulled demand forward into the first few months of the year. As the year progresses, we expect slower demand for raw materials as the shelves are already well-stocked. This dynamic will
cause overall economic output to moderate, but remain positive in our view.

Despite a slowing economy, we do not anticipate a recession within the next year.

Historically, expansions have ended when the Federal Reserve (Fed) aggressively hikes interest rates, often coinciding with rising inflation. Today, the Fed’s posture is different as it looks to sustain the current expansion; in early June, it acknowledged the slower growth outlook and rising trade tensions, and signaled that it stands ready to act as necessary to support the economy. We expect the Fed is likely to cut interest rates twice by the end of the year, starting with a quarter percentage point cut at the next meeting in late July. This would bring the Federal Funds target rate to 2.25%, which translates into cheaper borrowing costs at the expense of lower returns on cash. With inflation running below its 2% target, the Fed has room to act and we expect it will.

The rate of inflation is not only running below the Fed’s stated 2% long-run target, it is also decelerating.

The Fed’s preferred inflation measure, the Personal Consumption Expenditures Index, came in at 1.6% in May and now has fallen back to a level last seen in 2017 when the Federal Funds target rate was only 1.25% versus 2.5% today. This is both good and bad news. The good news is that low inflation gives the Fed more wiggle room to lower rates and it also helps consumption through higher real wages. The bad news is that with returns on cash and bonds already very low, and likely to fall further, we expect real returns on these assets (returns measured after the impact of inflation) to turn negative later this year. Simply put, cash and short-term bonds provide return of capital but little or no return on capital.

Despite a record long economic expansion, we do not see any large imbalances.

A closer look under the hood suggests that the most cyclical sectors of the economy appear to be in decent shape. Housing, business investment, business inventories, and auto sales account for about 21% of GDP, but close to two-thirds of the volatility in GDP. In other words, they can be unpredictable. Prior cycles have been driven by boom and bust changes in one or more of these categories, but we do not currently see large imbalances in these sectors, lowering the potential for negative shocks to economic output as conditions change.

Finally, the labor market remains strong. The most recent report indicates a very solid increase of 224,000 estimated new jobs in June. The unemployment rate remains low at 3.7%, which most would consider close to full employment. Where we see softness is in wage growth, a hallmark of the current recovery, with little indication that this dynamic will change soon. But the recent report bodes well for consumer spending, and likely gives the Fed additional room to gradually lower rates at a measured pace that soothes rather than spooks investors.

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