All data as of September 15, 2019, unless otherwise noted.
Executive summary
Global growth is slowing, and interest rates have plunged. The U.S. economy is still in its record-setting expansion, but vulnerabilities have increased due to the corrosive impact of policy uncertainty. We offer a survival guide to this increasingly challenging landscape, including the top indicators we are watching. We don’t forecast a recession over the next two years, but low interest rates, higher volatility and eroding fundamentals all mean investors could require a more sophisticated tool kit.
Global growth hits the skids
The global economy decelerated sharply over the past quarter, increasing the headwinds facing U.S. growth. Germany and the U.K. both experienced negative growth in the second quarter, and global measures of industrial production and sentiment are moving lower. The OECD recently downgraded its global growth estimate to 2.9%, the slowest since 2009, which was the last year of the Great Recession. China’s growth is expected to slow to 6.1%, the lowest in decades. This has rightly raised the question of whether this global slowdown will be the final straw that breaks the record-long U.S. expansion.
Back in the U.S., growth in 2019 has evolved broadly as we had expected. GDP in the first half averaged 2.6%, down from the blistering pace of 2.9% growth in 2018. But growth continues to decelerate. We still expect GDP of roughly two and a quarter percent in 2019, which implies growth of 1.7% in the second half of the year. Markets are naturally challenged by slowing growth, but given estimates of the U.S. underlying potential growth rate of 1.9%, our outlook for 2019 is hardly pessimistic.
Looking beyond the next quarter, however, the picture is certainly complicated enough to require a survival guide. One fresh concern is that U.S. growth has become significantly lopsided. In Q2, consumer spending grew 4.7%, while the entire rest of the economy contracted 3.7%.
The consumer will make or break the expansion
Increasingly, the fate of our expansion lies in the hands of the consumer. Consumption makes up 69% of the entire U.S. economy, dwarfing other sectors, and a necessary condition for recessions in the past has been a contraction in household spending. This puts the consumer squarely in the spotlight of our outlook.
Happily, the consumer is well supported, and the outlook remains positive. One of the clearest signs that the volatility that has afflicted Wall Street has not hit Main Street is strong levels of consumer confidence. Two key measures of consumer sentiment remain near expansion highs, and one of our favorite bellwether indexes – the spread of consumer expectations to present situations – remains elevated as well. Global trade tensions could put a significant dent in consumer sentiment, particularly as the next tranche of tariffs stands to include many consumer goods. However, looking ahead, we expect the consumer to only bend and not break.
The labor market is another critical sector that will influence household spending and, therefore, the trajectory of the economy over the coming quarter. Initial jobless claims remains our favorite indicator both for the labor market, in general, and as a potential warning sign that a recession is coming. Currently, initial claims rest near multidecade lows, a reflection of the tight labor market and a sign that despite heightened uncertainty around trade and global growth, companies have not yet resorted to layoffs.
In contrast to the upbeat picture of consumer confidence and the labor market, business sentiment is wilting under the strain of slower global growth and last quarters’ further escalation of U.S.-China trade tensions. Yet even here, the impact has been uneven. Measures of manufacturing sentiment have soured notably over the past quarter, with the ISM Manufacturing Index moving below the 50/50 boom/bust line for the first time since 2016, while the nonmanufacturing measure that reflects services has fared better. To us, a more severe erosion in business sentiment is one of the biggest risks to our view, particularly as we enter 2020 and election rhetoric could make the regulatory outlook highly uncertain.
Put together, this creates a landscape of an economy that we expect to slow further but we expect will avoid a recession, at least in 2020. Growth could swoon to an uncomfortably slow pace, however, and could even include a quarter of negative growth. Investors are too focused on whether or not the economy is going into a recession (bad outcome) or not (good outcome). They are missing the most likely outcome: sluggish growth that avoids a recession but still causes equity market valuations to recalibrate and bogs yields down at or near historic lows.
Global pessimism is creeping in
This outlook for slowing growth that avoids a recession gets riskier as the non-U.S. developed world decelerates. We have long noted that trade uncertainty is the biggest risk to U.S. growth. Over the past quarter, trade tensions escalated further, and a fresh round of tariffs is expected to more significantly impact households in Q4.
Trade-related uncertainty has impacted non-U.S. developed economies, with a reverberated impact to the U.S. investor through lower global interest rates. Indeed, one of the most notable trends of Q3 was the plunge in international interest rates. This was partly driven by global central banks swinging toward easier policies, and partly because global growth has broadly disappointed. There remains the critical question of how far global central banks are willing to engage in further rate cuts, and the overarching doubt about how impactful these will be in stimulating growth in the face of uncertainty.
Yield curve inversion is another sign of global pessimism, as the 3M-10Y spread has been negative for almost all of the last four months. While we agree markets are correctly forecasting a slowdown, we think there are three reasons to rethink yield curve inversion in this cycle. We are watching the signal the yield curve is sending closely, but think the interpretation may need to be more nuanced.
Finally, other international factors have added to the volatile nature of the global climate. China’s devaluation of the yuan in late August caused the dollar to surge on a trade-weighted basis. Currencies are now front and center in the political debate, with speculation that the U.S. may even push for intervention to weaken the dollar in the coming months. This new front in the trade war needs to be closely monitored.
Survival of the steadiest
This, then, is the landscape that investors need to survive. What is in the tool kit of the investor to manage an environment of slow global growth, low interest rates and higher volatility? Slower global growth will ratchet up uncertainty and pressure on the profit outlook for large multinational companies. Central bank policies may – or may not – reignite growth but will definitely keep interest rates low. We expect the U.S. economy to avoid a recession but to be increasingly lopsided. In this environment, month by month, the data could easily temporarily surprise to the downside, causing alarm bells to sound and feeding back into higher volatility.
Managing this volatility will be increasingly difficult. For equities, stock buybacks were a support for valuations throughout 2018, yet the first half of 2019 saw the pace of buybacks slow. This support for equity prices is eroding at the same time as global growth is looking increasingly shaky and trade uncertainty is as high as it has been during the past two years. While equities have strong year-to-date gains, the S&P 500 is up only 2.0% from a year ago.¹
Traditional fixed income markets have traditionally offered shelter from the storm of volatility and, on the surface, assets like the Barclays Agg have performed very well this year. And yet these gains have been almost entirely managed through price appreciation. Going forward, low interest rates are going to limit returns from income. Even worse, the dark side of duration became painfully evident as volatility has risen significantly in the traditional space, negating one of the primary reasons to seek an income-driven allocation.
