(January 7, 2019) – The financial media has spent much of the last quarter saturating investors with esoteric stories about impending trade wars, the impact of Brexit, and a roaring U.S. economy that’s arguably on the brink of overheating. Economists seem to agree that while global growth in the near terms has peaked, it has also become more unevenly distributed across regions. Accordingly, a waning bull market in stocks and global central banks bias toward raising interest rates emphasizes increasing economic divergence and differentiation between and within asset classes, both of which are typical of an aging expansion. Caught in the middle of this economic turbulence is the U.S. Federal Reserve, an independent institution walking a tight-rope of financial uncertainty between bolstering continued economic growth while tampering the effects of inflation.
The Good: Please Don’t Stop the Music
The United States is enjoying one of its best economies seen in a decade. GDP is growing at about 3.5 percent a year, which is roughly a point faster than many experts forecasted just two years ago. America is the middle of the second-longest recovery in its history, and if it lasts for another eight months it will be the longest ever. If someone were born in 1975, they would have seen the U.S. economy triple in size over the course of their lifetime.
Real domestic GDP growth in the middle quarters of 2018 logged in north of 3%– roughly double the rate from the previous sixteen quarters. Earnings growth for the S&P 500 has been 25% or higher in every quarter of 2018—a hair-raising pace usually only seen in the bounce of a recession. And the U.S. Bureau of Labor Statistics show the current unemployment rate, at 3.7%, a 49-year low.
The Bad: As Good as It Gets?
Despite all the good news, economists expect real GDP growth to slow into a 2% – 2.5% range in 2019, reflecting less support from fiscal stimulus, the ongoing removal of monetary accommodation, a stronger dollar, and a less favorable trade environment. Moreover, the punitive base effects from the 2017 corporate tax cuts, and accelerating input costs related to inflationary pressures, could lead to a sharp slowdown in U.S. earnings growth, from 25% in 2019 to 8% in 2019.
A survey of economists forecasted 2019 job growth averaging 150,000 per month, unemployment declining further towards 3.5%, and core CPI inflation to peak at around 2.5% year-over-year in response to a tightening labor market and the lagged effects of tariff increases.
The Fed: It’s Complicated
With nine rate hikes in three years, the Fed is trying to balance the risks of moving too fast and squelching the U.S. expansion and moving too slowly, allowing the economy or financial markets to overheat. Economic activity in the major economies, while slowing, is still likely to keep expanding at an above-trend pace and thus absorb more of any remaining slack in labor markets. However, members of the Federal Reserve’s Board of Governors are debating the need to transition monetary policy into a restrictive setting to ensure the U.S. economy doesn’t overheat. Do the potential returns of lower interest rates justify the risks of inflation? It’s a question that often gets asked in investment meetings and one that should have added emphasis in 2019.
Regarding interest rate markets, low volatility over the past two years suggests that the Fed has achieved its dual mandate of full employment and price stability. However, if forecasts for gradually accelerating inflationary pressures are right, it could be time to take the punch bowl away. While the deliberations have been largely overshadowed in recent weeks by speculation over a shift in the Fed’s tightening trajectory and the fate of its $4.1 trillion balance sheet, where they lead could have dramatic consequences for financial markets.
Meanwhile, the onset of the Fed’s balance-sheet unwind has slowly begun to drain liquidity from the financial system, to the point where many in the market are suggesting bank reserves are once again poised to become scarce. In addition, a surge in Treasury-bill issuance — and a corresponding increase in yields — has helped push other key short-term rates higher, especially in the market for repurchase agreements. As these short-term assets became more attractive alternatives to lending reserves to other banks, the availability of funding has lessened, putting upward pressure on the fed funds rate.
The fifth set of a Wimbledon tennis match, which comes without a tie-breaker, can be one way to describe the late-cycle state of the U.S. economy; it can last a long time if excesses and major policy mistakes are avoided. So, while being mindful of the risks of an early end, many believe it is too early to run for the hills.
The December 2018 Fed rate hike implied that the U.S. economy was doing great, while the stock market’s negative reaction suggests it could be headed toward a recession. So far, none of the domestic imbalances that typically precede recessions have developed: over-consumption, over-investment, a housing bubble or excessive wage growth. However, much will depend on whether the Fed will push rates significantly above neutral, with suggests a Fed Funds rate in the range of 2.5% – 3.0%. However, given a global economy that is “growing but slowing,” there is the potential for higher macro uncertainty and volatility. Lastly, core inflation in the U.S. is set to rise above the Fed’s target at a time when the labor market is tight.
The 2019 U.S. economic engine is running in the red, and the “check engine” light is on. Will the Fed take its foot off the accelerator to slow down, or will it continue driving the economy like everything’s okay?