Executive summary
The economy is slowing – an uncomfortable prospect for markets. We expect economic growth to slow to around 2% in 2019; however, risks to this outlook have risen significantly. Policy uncertainty from multiple directions, including trade tensions and the Fed, could negatively impact the economy and amplify market volatility. This will pose challenges for investors, even though we expect the U.S. economy to avoid a recession for now.
Growth as good as it gets
GDP grew 2.9% in 2018, matching the fastest pace of this expansion and well above most estimates of our potential growth rate. That robust pace of growth was fueled by corporate tax cuts in 2017 and an added boost from greater fiscal spending. But in the first half of 2019, investors were reminded that the economy is still up against structural headwinds like low labor force growth and slow productivity gains, and the economy is now losing momentum.
While we expect growth to slow, we still forecast a moderate deceleration to a relatively soft landing around 2%. The consumer, the largest sector of our economy, is looking healthy and continues to be supported by positive fundamentals. The unemployment rate remains at a multidecade low, and asset prices, along with a relatively healthy household balance sheet, indicate spending by consumers will continue to drive economic growth. This outlook for consumption is a critical part of our forecast that the economy will avoid a recession.
More broadly, the economy is now in its 11th year of expansion, the longest run of uninterrupted growth since World War II. And yet this expansion has also experienced the slowest growth, averaging just 2.2% since the end of the Great Recession. After all of the pro-growth policies of the last two years, the economy is reminding investors that the structural challenges to growth – low labor force growth and sluggish productivity gains – remain unresolved. Our “soft landing” outlook is a relatively optimistic one that could still feel stagnant by historic comparison.
The corrosive effects of policy uncertainty
Risks to our soft-landing outlook have grown significantly, however. Trade tensions are the biggest risk to the expansion and have a corrosive impact on markets, business sentiment and the consumer. Many headlines on trade have focused largely on China, but there are ongoing trade negotiations with most major U.S. trading partners. In May, it was the unexpected announcement of tariffs on Mexico that shattered market complacency. Even if trade negotiations bear fruit and fresh tariffs are avoided, the increased volatility alone will pose a significant challenge to investors.
Monetary policy has seen an extraordinary shift so far in 2019. Just a little over six months ago the Fed was expected to raise rates about two more times. Now, markets are pricing in over three cuts by the end of 2019. Paradoxically, this extremely dovish pivot could actually add to market volatility going forward. Markets may be building in a reliance on rate cuts beyond what the Fed intends to deliver, which would be painful for equities to reprice. We see risks that the Fed could add to market uncertainty instead of offsetting it.
Whether the Fed delivers with one or three rate cuts, interest rates have plunged, a sign that fixed income markets are pessimistic about the growth outlook. Over the last quarter, the 10-year U.S. Treasury yield has fallen from 2.41% to just around 2.00%. This isn’t just a U.S. phenomenon: In Germany the 10-year yield fell to -33 bps, the lowest ever, and the rest of the developed world has also seen interest rates drop. The amount of debt outstanding with negative yields has hit another record high and, along with overarching policy uncertainty, will keep U.S. interest rates low for the foreseeable future.
Sentiment indicators are more important than ever
Sentiment indicators are the data we will be hyper-focused on in the coming months. Business sentiment has deteriorated notably over the last quarter and poses one of the biggest risks to our forecast. Trade tensions are starting to pose a significant risk to business confidence, and this uncertainty has, in part, already caused investment spending to slow. Should business investment weaken further, it could push growth from moderate to stagnant.
Consumer confidence has proven more resilient to policy uncertainty so far. Yet because the consumer is the single largest sector of the economy, consumer confidence becomes even more of a focus for our forecast that the economy will avoid a recession. Currently, however, multiple factors are supporting consumer confidence, which remains near cycle highs.
Don’t ignore key recession indicators
We are not forecasting a recession, and yet we are the first to acknowledge that risks have grown. In particular, yield curve inversion is casting a shadow on the economic outlook. Yield curve inversion has proven to be accurate historically in signaling that a recession could begin in the next four to six quarters. While there are factors that could mean this time is different, including international pressure pushing down long-term interest rates, we are watching yield curve inversion closely.
Initial jobless claims are our other canary in the coal mine – a historically good leading indicator of a recession. Happily, initial claims rest near multidecade lows, a reflection of the tight labor market and a sign that despite heightened policy uncertainty, companies have not yet resorted to layoffs. Still, with risks to the economy arguably on the rise, we are watching initial claims even more closely in the second half of the year.
Equity volatility looms, high yield stands to benefit
As if the economic slowdown and heightened policy uncertainty weren’t challenging enough to navigate, investors are also faced with equity markets flashing optimism while fixed income markets reflect caution.
Equities are on pace for their best year of this expansion, as the Fed’s dovish pivot has fueled stellar returns and kept realized volatility below historical averages. Yet a perfect storm of policy uncertainty is brewing, and we expect volatility to emerge in the second half of the year. Even beyond the possible impact on earnings from slowing global growth and rising tariffs, equity markets may be overly reliant on Fed rate cuts. Stock buybacks remain at record highs, however, which could support equities even if it won’t quell volatility.
Fixed income, however, is likely to show a divergence between core fixed income and high yield performance. We see the current environment of declining long-term rates and low corporate defaults as especially conducive for high yield bonds. Falling benchmark interest rates have recently provided a boost to core fixed income investments, but low (or negative) global central bank policy rates mean core fixed income has been beaten into a corner by rates. In this environment, investors need to look beyond the core, and high yield offers an attractive combination of exposure to growth upside alongside amplified income returns.
