By Thomas Dillman
In the weeks since we posted the July 2019 issue of Economic Perspective, much has happened to upset the financial markets. Mutual of America Capital Management LLC explores the reasons for the volatility in the markets – including the recent interest rate cut by the U.S. Federal Reserve and ongoing trade issues between the U.S. and China – and provides an outlook on the U.S. economy and markets moving forward.
Markets React to Fed Action
As anticipated, the Federal Reserve lowered the Fed Funds rate by 25 basis points on July 31, the first reduction in more than 10 years. Despite meeting market expectations, comments by Fed Chairman Jerome Powell following the meeting suggested that further rate cuts might not be as forthcoming as investors had believed. Furthermore, two of the seven members of the Board of Governors dissented, a rare occasion in the case of significant changes in policy. The bond market's reaction was immediate; the 10-year Treasury note dropped 15 basis points within hours to 1.85% – a clear indication that bond investors were even more skeptical than before the cut that a Fed rate reduction cycle would re-stimulate the economy, and that a single cut would not do the job.
The stock market reaction was different. Powell's comment that the rate cut was a "mid-cycle correction" was sufficiently ambiguous for equity investors, who retained their more hopeful outlook that the Fed would follow through with more cuts in the near term. After a 1% drop in the S&P 500® over the two hours following the rate cut announcement, the market rallied sharply during most of the next day. Then, shortly before the market closed, President Trump tweeted that he had decided to implement a 10% tariff on the remaining $300 billion of annual U.S. imports from China, effective September 1. Trump explained that Chinese leaders showed little interest in making progress on a deal during that week's restart of negotiations following the truce agreed to between himself and President Xi only a few weeks earlier. Trump also claimed that China reneged on resuming purchases of U.S. agricultural goods. From all reports, President Trump made these statements unilaterally, against the advice of his advisors, with the exception of Peter Navarro, his top trade consultant.
From the S&P 500's high of 3,025.86 on July 26, prior to Trump's tariff announcement, until the market close at 2,844.74 on August 5, the Index declined nearly 6%. The 10-year Treasury note also dropped further to 1.72%. In short, it appears the stock and bond markets' respective declines were based on the notion that the Fed had done too little and the President had done too much.
A significant contributor to the -3% equity market rout on August 5 was the sharp drop in the value of the Chinese currency over the weekend in response to the Chinese government's modification of the acceptable trading range for the yuan. The Trump administration immediately accused China of manipulating its currency to gain the competitive advantage of lower prices in global trade. Currency manipulation is prohibited by the International Monetary Fund Articles of Agreement, but there is no enforcement mechanism. The World Trade Organization has no specific provisions regarding currency manipulation.1 China denied the accusation, though most likely it was responding to Trump's tariff threat. However, in response to the turmoil created in the foreign currency markets, China took steps to stabilize the yuan.
Economic Growth Slowing Globally
As noted in the July issue of Economic Perspective, Fed policy and the trade issue seem to be the prime drivers of this year's market behavior and volatility. However, we also noted that the larger issue is the sustainability of the current expansion, which is dependent upon Fed policy and what happens with the trade dispute. There is no question that economic growth has slowed globally. European growth has deteriorated for the last year and a half, and Japan's growth is marginal. China has struggled to maintain its 6%–7% growth rate for the past several years – first trying cycles of massive fiscal stimulation followed by periods of restraint, and more recently through various modest structural changes designed to collectively make the economy function more effectively on a longer-term basis without massive interventions by the government.
During the first half of 2019, the U.S. economy also showed worrying signs of slowing growth, especially in terms of consumer spending and business investment. The ISM Manufacturing and ISM Non-Manufacturing surveys of purchasing managers for most developed and developing countries has declined for well over a year, with most nations now registering results around 50, the break point between growth and slowdown. Inflation remains below what central banks generally agree is an optimum rate of 2%. In theory, this suggests an underlying weakness, or at least less of a bulwark against deflation in the case of recession. Oil prices are down 20% since peaking in late April. Interest rates remain low worldwide, and are below zero in key economies such as Germany and Japan. It is estimated that sovereign bonds valued at over $15 trillion around the world pay no interest or will redeem for less than their original face amount.2 In the U.S., short-term interest rates are lower than any long-term government rates up to10 years' maturity, a historically reliable pre-recession signal.
We are not forecasting a recession, though the risks of recession are steadily climbing. But there are some potentially offsetting positives. Japan is continuing its quantitative easing program, the Fed just lowered interest rates, and the European Central Bank (ECB) just announced it will resume buying bonds, both sovereign and corporate. In the U.S., there are encouraging signs that the economic weakness experienced during the first half of this year is beginning to reverse. Resurgence in retail sales and continued healthy employment growth support the notion that U.S. growth, while not booming, is not falling off a cliff. Second-quarter corporate profits are coming in above consensus estimates, and positive surprises are easily outnumbering negative surprises, although year-over-year profit growth remains in low single digits, and the limited corporate guidance provided thus far has not been upbeat.
In the meantime, the effectiveness of Fed policy going forward and the trajectory of trade negotiations between the U.S. and China remain wild cards. An early resolution of the trade war would be a huge positive – both for economic growth and the equity markets. Further cuts by the Fed would be positive for the housing market and for investor sentiment, though the full impact of rate reductions is generally only realized over the subsequent six to twelve months.
One final, but important, observation: the 2020 U.S. presidential election cycle has begun. The Democrats already had two debates that make clear both the wide spectrum of beliefs and policy initiatives that exist across the party. However, the policy balance among those Democrats currently leading in the polls is decidedly more liberal (and socialist at the extreme), more anti-establishment, and more committed to much greater government involvement in all aspects of society – including healthcare, the environment, education, income distribution, immigration, the financial markets and the economy in general. The rhetoric is almost assuredly going to roil markets, especially if the ultimate Democratic candidate for president is from the far left on the political spectrum.
We usually say that politics has less of an impact on the economy than generally imagined. That was true when the two parties' differences were less extreme. Some of the Democratic candidates' platforms aim to significantly and, in some cases, drastically transform the structure and functioning of the U.S. economy. Whether such programs would be good or bad for the country is a matter of opinion at this time, but there is little doubt that investors will be deeply concerned and are likely to act in a way that is sure to magnify volatility.
Thomas Dillman is the former President of Mutual of America Capital Management LLC.
|1||Jonathan E. Sanford, "Currency Manipulation: The IMF and WTO," Congressional Research Service, January 28, 2011.|
Wall Street Journal, "Investors Ponder Negative Bond Yields," August 12, 2019.
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.
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