by Thomas Dillman
As the United States economy continues its decade-long expansion, recent volatility in the financial markets and signs of a slowing global economy are giving pause to the prospect for sustained growth both in the U.S. and around the world. Mutual of America Capital Management LLC explores a number of key factors leading to the current uncertainty, including rising interest rates in the U.S., a stronger dollar, increasing risks within the U.S. bond and equity markets, the increasing impact of tariffs, and global tensions on trade, among others.
Current U.S. economic data continues to indicate strength in the economy. Most reports, except those regarding housing and autos, remain at levels higher than their averages during most of the expansion. Gross Domestic Product (GDP) accelerated to a 3.0% average during the first half of 2018 – following 2.2% and 4.2% growth in the first and second quarters, respectively – versus an average of 2.0% over the past eight years; moreover, the preliminary third-quarter GDP report indicated 3.5% growth. Consumer spending remains the main driver of growth, and recently was joined by a capital spending resurgence fostered by the tax cuts effective at the beginning of this year. Consumer and business confidence remain high. The Institute for Supply Management’s Purchasing Managers’ Index for both U.S. manufacturing and U.S. non-manufacturing indicate continued expansion. Monthly employment gains continue to register near levels maintained for the past several years despite a current unemployment rate of 3.7%; unemployment claims are at historically low levels; and there are more jobs available than workers to fill them. By almost any measure of economic health, the U.S. economy is booming. So, why the sudden re-emergence of volatility in the markets? Following is the set of risks we believe accounts for the recent rise.
European Union Grapples with Internal Issues
Economic conditions around the globe are weak and, in many cases, deteriorating. European economic growth has weakened, largely due to a variety of issues facing France and Italy. More importantly, the European Union (EU) is facing two possible threats to its existence. The first is the fast-approaching March 31, 2019, deadline for an agreement with Great Britain to leave the EU. The concern is the unintended consequences of an absolute break that would immediately sever the myriad economic and financial connections between the two. Negotiations over the past two years failed to achieve an agreement to retain some economic links while dissolving compliance with EU rules, especially those regarding open immigration. As a result of the EU’s adamant rejections, Prime Minister Theresa May is under threat of being ousted by her own party.
The second threat confronting the EU is an ongoing debt crisis in Italy: the country’s total sovereign debt is 130% of its GDP, high compared with other developed countries and compounded by its weak economy. The coalition of two populist parties created following the most recent election submitted budgets that are unacceptable to EU authorities under their rules regarding maximum annual deficits for member nations. Such deficits add to the already heavy debt burden. However, the controlling coalition got elected with promises of expensive social programs and has displayed limited inclination to bend to EU demands. The specter of Italy withdrawing from the EU is reminiscent of the Greek debt crisis. In this case, however, Italy is a much larger and more important constituent of the EU, and its exit, along with Britain’s, would beg the question of whether the EU, could remain a viable political and economic entity. Unlike the situation with Greece, the EU could not afford to bail out Italy if the country defaulted on its sovereign loans.
China Growth Rate Lowest in Decades
China is facing a number of dilemmas of its own. For the third quarter of 2018, China reported a year-over-year GDP growth rate of 6.5%, its lowest in at least 20 years, continuing a long-term trend. The government knows its economy has to slow, given how large it has become, but has tried to control the slowdown to avoid a recession and thereby precipitate a financial crisis that would affect the global economy. The tactic has been to alternate between restrictive and stimulative monetary and fiscal policies, including raising and then lowering interest rates, as well as discouraging and then encouraging lending to spur investment. In anticipation of the recent reports acknowledging weakened growth, the government began another stimulative campaign that includes lowering rates, promoting lending, cutting taxes on business and consumers, and various regulatory reforms. The real problem is that after years of promoting growth, debt levels have reached such extremes, especially for businesses, that if the economy were to slow at a quicker pace, bankruptcies would mushroom beyond the government’s ability to stem the tide. The recent implementation of U.S. tariffs on more than $250 billion of Chinese imports will add additional stress by reducing the U.S. contribution to Chinese growth and, furthermore, will put pressure on Chinese sovereign reserves, one of the primary backstops for curbing a debt crisis.
Emerging Markets Struggle with Their Economies
As for the economies of emerging markets, most have struggled as a result of rising U.S. interest rates and the strong U.S. dollar, especially those with high levels of dollar-denominated sovereign and/or business debt. As the U.S. dollar strengthens, foreign currencies weaken. Thus, as interest rates rise, interest payments and debt pay-down required to be paid in U.S. dollars become more expensive for the foreign debtor. In response, monetary authorities are forced to raise their own interest rates to buoy their currencies and contain rising inflation that tends to accompany such episodes. But raising rates curtails growth, making it more difficult to generate the income to service and pay off the debt. Not all emerging-market economies are affected equally – those with lower debt as a percent of GDP and stronger foreign currency reserves are better positioned to control the effects of rising dollar rates. Turkey, Argentina and Pakistan are the weakest economies in this regard, but most emerging markets have still come under incremental stress despite their relatively solid financial health. As a result, the stock markets of most emerging markets have suffered.
In summary, the U.S. economy is thriving while most of the world’s other economies are growing only modestly or are slowing.
U.S. Interest Rates Affect Global Economy
U.S. interest rates not only affect the U.S. economy but the entire global economy. However, part of the Federal Reserve’s official responsibility is confined to pursue full employment and low-and-stable inflation in the U.S. After years of flooding the global financial system with liquidity through quantitative easing to address the Great Recession of 2008–09, the Fed began to reduce and ultimately ended the purchase of bonds. In December of 2015, it began to raise the Fed Funds rate in increments of 25 basis points, from essentially 0% to a current range of 2.00% to 2.25% after its eighth increase this past September. In the announcements that followed its last several meetings, the Fed made little mention of external repercussions of rate hikes. However, the Fed is fully aware of potential global impacts of its interest rate policy, just as it was that its quantitative easing program (along with those of Great Britain, the European Union and Japan) was designed to save the world economy and financial system from implosion following the Great Recession.
Nonetheless, given the current and expected strength of the U.S. economy, the Fed has little alternative but to continue to remove liquidity. Inflation, both in wages and consumer prices, is rising after years of stagnation, though not yet at overly worrisome levels. The Fed must be vigilant not to let the U.S. economy overheat and inflation surge. Knowing the exact level at which to stop raising rates without throwing the economy into recession is extremely difficult. In fact, there is one case when the Fed raised interest rates and that was not followed by a recession within a 6-to-18-month period: during the 1990s expansion, when the Fed paused its rate-hiking program in 1994 in response to a modest acceleration in growth and inflation, and then actually lowered rates until the end of 1998. That pause was partially blamed for the subsequent tech bust in 2000. Whether the Fed will pause this time around remains to be seen.
How fast and how high the Fed will continue to raise rates are the most pressing concerns of investors right now, and have played a major role in making significant advances in U.S. stock prices so difficult this year despite accelerating growth and corporate earnings. The current consensus is that the Fed will raise rates another 25 basis points at its upcoming December meeting. The Fed itself suggested it will implement three more similar hikes in 2019, with the customary caveat that any decision on rates will be data dependent. However, if there are four more rate hikes before the end of 2019, rather than three as currently expected, the Fed Funds rate would stand at a range of 3.00% to 3.25%, around the same level as the current rate on the 10-year U.S. Treasury note.
Trade Agreements Weigh Heavy
Another major concern of investors is the effect that U.S. tariff policy will have on U.S. and global growth. As discussed in the September issue of Economic Perspective, the prime target of President Trump’s administration’s tariff policies is China. Efforts by the U.S. to establish “fair trade” with most other major trading partners have been, or are in the process of being, negotiated. The U.S., Mexico and Canada recently agreed on revisions and updates to the North American Free Trade Agreement (NAFTA), in a deal called the United States-Mexico-Canada Agreement (USMCA). The U.S. also concluded negotiations with South Korea, agreeing to more favorable trade terms, and is in the process of negotiating new agreements with Japan and the European Union. However, trade talks with China were terminated following the implementation of a 10% tariff on $200 billion of Chinese goods, effective at the end of September, and scheduled to be raised to 25% on January 1, 2019. Tariffs on an additional $60 billion were already in effect. Furthermore, Trump threatened tariffs on an additional $200 billion of Chinese imports. At that point, the current total of Chinese imports would be subject to U.S. tariffs. There is an outside possibility that talks could resume after Trump and President Xi Jinping meet at the upcoming G20 summit in November. History suggests that China will not back down from the confrontation; but with the Chinese economy and financial system at a vulnerable stage, and the U.S. economy and financial system running on all cylinders, the U.S. might have enough leverage to encourage China to come to some kind of agreement.
However, the aggressive U.S. trade strategy is not exclusively aimed at establishing a better balance on trade issues with China, but is also aimed at the much deeper and longer-term concern about the clear Chinese goal to become a dominant, if not the dominant, economic and military player on the international scene. One example is the creation of Chinese militarized islands in the South China Sea, in what most observers believe is a clear intent by China to control the sea lanes of Asia. Another is China’s Belt and Road Initiative to build a global trade network that would create land and sea routes throughout Asia, the Middle East, Africa and eventually Europe, and would acquire existing routes in South America. The U.S. is also seeking to eliminate the transfer of U.S. technology know-how to Chinese companies, which is a key requirement by China for U.S. corporations to enter the Chinese market.
In short, the U.S. is attempting to slow and constrain the limits of Chinese expansionary policy. In the 1830s, the French political scientist and historian Alexis de Tocqueville, in his treatise “Democracy in America,” predicted that the key 20th-century international rivalry would be between the U.S. (then a small and struggling young nation) and Russia (then an expansive, resource-rich – although relatively poor – country ruled autocratically by the Romanoff tsars). However, since 1989, when the Berlin Wall fell and the Soviet Union’s control over its Eastern European satellite domain collapsed, China was already in the early stages of becoming the most likely threat to U.S. hegemony in the 21st century. Currently the second-largest economy in the world, growing at least twice as fast as the U.S. and with what has become a clearly articulated strategy to challenge U.S. leadership, it appears China has stolen a march on the U.S. That, at least, seems to be the view of the Trump administration, which explains its forceful push-back on Chinese intentions.
U.S. Growth Outpacing Rest of World
Meanwhile, with regard to equity markets, the U.S.’s were among only a handful globally to achieve positive results year-to-date through the middle of October – and those markets outside the U.S. that managed to advance do not represent more than a fraction of the world’s GDP collectively. These results reflect the difference between U.S. growth and that of the rest of the world. The reasons are many, including rising U.S. interest rates; a strong U.S. dollar; high and potentially rising commodity prices, especially oil; and a reordering of the global trading system because of U.S. tariffs – all of which have compounded the internal structural problems facing most other economic entities.
U.S. growth and corporate profits have received a tremendous dose of fiscal stimulus as a result of the passage of the Tax Cuts and Jobs Act at the end of last year. The effects of these tax cuts will fade in 2019, and thus, corporate earnings comparisons will become much more difficult and will come nowhere near the year-over-year gains seen in the first two quarters of 2018. In the meantime, about 60% of S&P 500®; companies have reported third-quarter earnings as of this writing, with results running about 3% above beginning-of-quarter expectations. Moreover, 69% and 40% of companies have exceeded expectations on earnings per share and sales, respectively, about par for this point in the reporting cycle. However, particularly worrisome is the fact that, unlike most periods of earnings reports in the past, positive surprises are not being rewarded with outperformance following the announcements of such.1 While third-quarter earnings are still looking to register year-over-year growth of about 25%, it is likely that analysts have based fourth-quarter earnings on the strength of the first two-to-three quarters, a not unusual occurrence following a period of robust earnings growth.
Almost all investors find it next to impossible to discern “peak” growth or earnings. When they do, they often do not have the courage to take appropriate action. That’s why recessions always seem to come as a surprise. The upcoming congressional midterm elections probably explain the Trump administration’s recent suggestion of a further 10% tax cut, as well as the President’s criticism of the Fed, and Chairman Powell in particular, for continuing to raise interest rates. Additional tax cuts and/or a slowdown or cessation in the rise in interest rates would be bullish for stocks. However, in our opinion, neither action is likely. The tax-cut proposal is well-timed for the upcoming elections, and would hit a dead end in Congress if consensus is correct that the Democrats will recapture the House of Representatives. The Fed, for its part, will ignore the President – a tacit assertion of its political independence.
Warning Signs of End of Bull Market
As we’ve noted in past issues of Economic Perspective, financial markets are a discounting mechanism, basing stock purchases and sales upon expectations for the future. The markets’ recent struggles and increased volatility reflect such concerns. Indications of increased risks that the economic cycle and, therefore, bull market, are nearing an end are piling up. Warning signs of an approaching inflection point in the business cycle include: rising interest rates; rising wage rates; rising consumer prices; the approaching end of fiscal stimulus; the increasing impact of tariffs; slowing GDP and earnings growth; a flattening yield curve, slowing global economic growth; and rising U.S. and global sovereign and business debt, among others. Portents of risk are appearing within the dynamics of both the U.S. equity and bond markets. Valuations are stretched, especially if one excludes the increment from tax cuts to more adequately reflect sustainable earnings. The yield on the Fed Funds rate, the lowest interest on the yield curve, recently surpassed the yield on the S&P 500®, meaning that bonds have become competitive with stocks for the first time in a decade. U.S. corporate debt is increasing despite the generation of historically high amounts of cash flow and the repatriation of corporate profits from abroad as permitted by the new tax law.
A closer look at the bond market reveals that the outstanding issues of triple-B rated corporate bonds, the lowest tier considered investment grade, has grown in size to equal all A-rated bonds. Put another way, triple-B rated corporate bonds are 50% greater than the total amount of outstanding investment-grade corporate debt (AAA to BBB-) of $1.7 trillion at the peak of the last cycle in 2007. Today, investment-grade bonds total $5 trillion. Add to that all junk bonds and leveraged corporate loans–each amounting to about $1.2 trillion, and combined, about the same size as both A-rated and triple-B rated bonds taken separately, or almost $2.5 trillion.2 The total outstanding amount of junk bonds and leveraged loans combined has doubled since 2007.3 To put this in perspective, the amount of all bonds and leveraged loans represented 20% of GDP in 2007. The figure now is 38.5%. And this is to say nothing about the growth in sovereign U.S. debt. This time around, however, consumer balance sheets seem to be in good shape. For instance, outstanding residential mortgages have not yet returned to 2007 peak levels. The big problems of the next recession are more likely to center on the corporate bond market, with equity markets affected, as well.
We are not calling for a recession in the U.S. in the near-term, but believe the country is approaching the end of this economic expansion. One subjective signal often cited as a harbinger of a bust is high and rising investor bullishness, which so far is not apparent, particularly among individuals. However, the bullish economists and strategists appear to be focusing more on current positives and neglecting the storm clouds on the horizon. Their argument is that the harbingers of end of cycles, including those we’ve noted, precede recessions by months if not a year or more. In our opinion, very few investors, economists or strategists have proven successful at timing the economy or the markets. There are indications of frothiness in the bond markets. And equity markets have developed structural vulnerabilities that tend to enhance volatility, such as algorithmic trading, exchange traded funds (ETFs), and private equity funds (because of their heavy use of junk bonds and leveraged loans), as well as certain small (but volatile and somewhat speculative) niches of the market such as Bitcoin and the marijuana producers.
Despite all the risks cited in this essay, the cycle likely has more time to run, and an end is next to impossible to call. A well-diversified portfolio, constructed in accordance with the investor’s risk profile and time-frame, continues to seem to be a reasonable approach. It’s worth noting that despite the bear markets of 1987, 2000–01 and 2008–09, the S&P 500® advanced an average of 8% per year over the past 30 years versus an average annual inflation rate of only 2.35%. Of course, past performance is no guarantee of future results. Still, in our opinion, and based on our experience and history, the odds of satisfactory outcomes from holding stocks over extended periods remain favorable.
Thomas Dillman is the former President of Mutual of America Capital Management LLC.
|1||Bank of America, “Earnings Season Update; Week Three,” Savita Subramanian, October 26, 2018.|
Bloomberg Opinion, “The Corporate Junk Market is Becoming Junkier,” Danielle DiMartino Booth, July 10, 2018.
Market Watch Opinion, “The Next Wreck in Junk Bonds Will Be Bigger, Longer, and Uglier,” Jonathan Rochford, June 16, 2018.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.