Market & Economic Outlook
Market Commentary Q4 2019 - Economic Outlook
Fourth Quarter 2019
Market choppiness in the third quarter was consistent with a mixed bag of global economic data and trade headlines that shifted day by day from optimism to pessimism and back again. Meanwhile, the attack on Saudi Arabia’s oil facilities briefly pushed crude prices higher, but demand for oil is ebbing worldwide as global growth slows. This issue of Perspectives discusses global markets and our outlook for the fourth quarter of 2019.
Market Overview: Investing in a World of Risk
Unlike the first half of 2019, an unusual situation that saw stocks and bonds rally in unison, global financial markets took many twists and turns in the third quarter. Equity markets rallied in July only to sell off in August under increasing trade policy uncertainty and a Federal Reserve (Fed) announcement that was not as dovish as investors desired.
Following a brief thawing of trade tensions, September saw equity markets claw back the lost gains and the S&P 500 index finished the third quarter up 1.7 percent. But bonds sold off aggressively to begin the month after better-than-expected economic data challenged the recessionary narrative triggered by a flattening yield curve.
Despite a brief spike in early September, the yield on the bellwether 10-year Treasury Note fell 34 basis points to 1.66 percent over the course of the quarter—a continuation of a persistent downtrend that began in mid-November 2018 when the yield hit a seven-year high-water mark of 3.24 percent.
In keeping with the Fed’s dovish pivot in January that helped spur equity markets, the Federal Open Market Committee (FOMC) cut the Fed Funds rate twice in the third quarter. Chairman Powell attempted to manage investor’s expectations by characterizing the easing as a precautionary “mid-cycle adjustment.”
Recent choppiness of financial markets has been consistent with a mixed bag of global economic data and trade developments that shift day-by-day from optimism to pessimism and back again.
On the manufacturing front, activity indicators are fading under the weight of unresolved trade tensions. Manufacturing weakness was particularly evident in the global economies more export-oriented than the U.S.—like Germany where manufacturing Purchasing Managers' Index hit their lowest levels in over 10 years. Facing increasing risks that the eurozone economy may fall into recession, the European Central Bank pushed rates further into negative territory from minus 0.4 percent to minus 0.5 percent, the first interest rate cut since 2016, and indicated that it was running out of tools to stimulate the European economy.
Consumers to the Rescue
Despite U.S. trade policy uncertainty weighing heavily on global manufacturing output, the more service sector-oriented U.S. economy remained relatively resilient during the third quarter with employment growth slowing, but still healthy. September’s non-farm payroll report, a closely watched barometer of economic health, served to temper fears of a broader slowdown as the jobless rate fell to 3.5%—its lowest level since December 1969.
With the U.S. manufacturing sector under stress, and consumer spending helping to keep the domestic economy expanding, investors keep a close watch on monthly consumer confidence surveys. One such measure, The Conference Board’s Consumer Confidence Index remains at healthy levels but, as shown in the chart below, September’s reading was the lowest in nine months due to “the escalation of trade and tariff tensions in late August,” according to The Conference Board’s release.
Looking ahead, the seesawing U.S./China trade negotiations are likely to persist and drive additional volatility as economic growth continues to suffer under a cloud of policy uncertainty which, according to the Organization for Economic Cooperation and Development, is behind their recent downgrade in the outlook for the global economy. For the U.S., the group trimmed its GDP forecast for 2019 to 2.4 percent and 2 percent in 2020 noting that “escalating trade policy tensions are taking an increasing toll on confidence and investment.”
We can’t understate the unpredictability of this unique set of macroeconomic circumstances, both in terms of their root cause and how they will be dealt with from a monetary policy perspective. As Chairman Powell said in his Jackson Hole speech regarding the Fed’s ability to incorporate the trade war into its playbook: “There are…no recent precedents to guide any policy response to the current situation.”
Thinking about the implications for portfolio strategy going forward, we must also acknowledge that, much like central banks, there is no precedent to guide investors through the thick fog of a major trade war. What we can be certain of as we examine the bigger picture, however, is that investors are most likely faced with living in a lower-return, higher-risk world where it is best to play defense instead of offense and seek a margin of safety by emphasizing the return of capital versus the return on capital. With equity returns during this economic cycle at twice their long-term averages, we expect returns to moderate and revert back to long-term trends.
There is also a systemic risk that globalization itself is unwinding and, as the apparent benefits from the pillars of globalization—new markets, global supply chains, peace arising from alignment of trade interests, etc.—weaken, risk premiums across the investment spectrum will rise.
As markets struggle with potentially increasing risk premiums, asset class price discovery could be complicated by the fact that many global economies operate in an environment of zero or negative interest rates which destroy both savings and investment: the foundations of future economic growth.
Negative rates also distort how investors analyze investment decisions. Because prices convey information, lack of accurate pricing delivers misinformation and unproductive capital allocation. Negative rates create a black hole where historical financial relationships and approaches are at risk of no longer being in force. We expect the impact of negative rates and unconventional central bank policies to play out over many months, if not years, and we will add this consideration to our structuring of client portfolios.
Ahead of the Curve: Policy Send Mixed Messages
The Federal Reserve’s second rate cut in the third quarter lowered short-term rates to a range of 1.75% to 2.0%. In easing U.S. monetary policy for the first time since 2007, Chairman Powell cited weakening business sentiment and investment, global growth doldrums, and declining exports as factors behind the change in direction.
The Fed’s calendar includes two more meetings this year and, according to the most recent “dot plot” projections, 7 of the 17 Federal Open Market Committee (FOMC) members forecast at least one more 25-basis point cut this year. But even as many members believe another rate cut is in the offing for 2019, divisions among FOMC voting members appear to be increasing and three dissenters at September’s meeting may point to Committee disharmony and murkier waters ahead.
While St. Louis Fed President James Bullard voted for a 50-basis point rate cut, two other members—Kansas City Fed President Esther George and Boston Fed President Eric Rosengren— voted not to cut rates at the September meeting. George and Rosengren had also voted to hold rates steady at July’s Federal Reserve get-together. While some reports cast the three dissenters as a record, the early 1960's and late 1970's were marked by frequent dissenting FOMC votes—at a total of 21 meetings, either four or five members voted against the policy recommendation.
George’s hawkish leanings date back to 2013 when she cast her first dissenting vote as a member of the Bernanke Fed. In all, she has dissented (voted to tighten) at 14 of the last 53 meetings under Chairs Bernanke, Yellen and Powell. She and Bullard have been on opposite sides of the policy debate twice so far in their overlapping tenures. It will remain an open question if other FOMC voting members adopt a Georgian orientation to break from the consensus and tighten rates in the future or side with Bullard’s preference for aggressive rate cuts.
Meanwhile, the market has sent a clear message that it wants/expects more rate cuts as reflected in the inversion of the yield curve. In August, the 2-year minus 10-year Treasury yield spread briefly turned negative for the first time since 2007. This occurrence followed the one- month minus 10-year spread, which has been in and out of negative territory since March.
Yield curve inversions are considered a signal that the market believes the Fed is too tight relative to economic fundamentals and that more aggressive easing is necessary. The Fed’s historical slowness to respond to these cues has been a common source of blame for why recessions eventually materialized. With the risk of economic overheating minimal, we believe the Fed should and will fall in line with the market—hopefully sooner rather than later.
Coming Up Short
The Fed was also in the news late in the third quarter when a liquidity crunch in the overnight/repurchase agreement (repo) market (the first such shortfall since 2008) led to an interest rate spike as banks and broker-dealers scrambled to find funds to lend to each other. The New York Fed, charged with keeping the repo market stable and liquid, auctioned about $53 billion in repo agreements and repeated the auction process on subsequent days to stabilize market demand.
Explanations for the repo market dislocation ranged from too hasty Fed tightening of its balance sheet to corporate tax deadlines to bank reserve requirements that created outsize demand for Treasuries. We are somewhat puzzled as to how these factors, none of which should have surprised the parties active in the repo market, could have led to such a funding crunch. What is clear, however, is that the cause of 2008’s repo market meltdown was bank- solvency related. This time around, the underlying issue is different - a fact that all market participants took comfort in.
The most concerning aspect of the liquidity crunch is that record Treasury auctions are part of the story, highlighting public debt expansion to record levels which we believe could weigh on the growth potential of the U.S. economy.
During the third quarter, the U.S. bond market digested news that the Treasury Department is researching potential market demand for a 50-year Treasury Bond. This new offering would push the yield curve out an additional 20 years and, according to Secretary Mnuchin, capitalize on low rates and help manage the record $1 trillion U.S. budget deficit. If there is sufficient demand, Mnuchin suggested 100-year Treasuries might also be on the table. Government bond portfolio managers responded cautiously to the idea of ultra-long Treasuries, with some suggesting that potential yield curve disruptions and low demand for the 50-year paper made the idea less than appealing.
One statistic illustrates the decline in the productivity of government debt: In the 1980s, 50 cents of debt was worth $1 dollar of GDP but today $1.50 of debt is required for the same impact on GDP. As shown in the chart below, government debt as a percentage of GDP continues to expand to levels not seen since World War II.
In addition to high levels of government debt, corporate debt as a percentage of U.S. GDP is at its highest level over the last several decades (as shown in the chart above). Credit expansion booms driven by low rates have historically led to busts and we believe today’s corporate debt market has become addicted to cheap, free-flowing credit. The Fed attempted to slow overall credit expansion in 2018 by raising short-term rates, but economic and market conditions led to an abrupt and dovish U-turn in monetary policy which has effectively served to keep the debt spigot open.
While the central bank’s policy pivot is well intended, we believe that the return to easier monetary policies may be contributing to the lack of equilibrium required to avoid asset bubbles. Given the potential for capital destruction when bubbles burst, one must question whether kicking the can by way of artificially extending the economic cycle via an easing bias is the lesser of two evils.
In light of our concerns about asset prices relative to fundamentals, our client portfolios continue to favor higher quality securities and sectors of the market. Such defensiveness should not be interpreted as an expectation of imminent market implosion, but rather a reflection of downside risk outweighing upside potential given current valuation levels.
Energy Market Outlook: This Is Not Your Father's Oil Embargo
The September 14 attack on major Saudi Arabian oil production facilities is the largest supply disruption in modern history (5.7 million barrels per day or 6% of global supply), larger than the supply shocks following the Iranian Revolution in 1979 and OPEC’s Oil Embargo against the U.S. following the Arab-Israeli War of 1973 to 1974.
Estimates of how quickly the stricken facilities can come back on-line range from weeks to months, depending on the damage and availability of replacement parts. Crude oil prices spiked on the news some 15% the day after the attack.
We believe that market reactions to the attack may be driven by more than a temporary tightening of the oil spigot, however. There are two reasons this time may be different: U.S. shale production and the declining role oil plays in the U.S. economy.
Shale to the Rescue?
Delivering 12 million barrels per day, the U.S. has moved from being a net importer of oil to leading the world in crude production. One reason for the modest price change in oil may be that, in addition to potentially releasing some of the 700 million barrels of crude in the U.S. Strategic Petroleum Reserve, investors believe the U.S. can ramp up shale production to plug the gap left by the Saudi attack.
Shale companies will also face higher financing costs and limited access to capital markets until investors become convinced they’ve learned their lesson. While these firms may be tempted to increase production, their shareholders will counsel patience.
Weaning Ourselves from Energy
The U.S. economy has also experienced some dramatic changes since the fuel shortages and gas lines of the ‘70s and is less vulnerable to crude oil price shocks. This is due to a shift from a manufacturing-led economy reliant on oil-based products (currently 11% of GDP) to one led by less energy-hungry service industries that represent around 70% of GDP.
As shown in the chart below, energy intensity for the U.S economy, as measured by consumption per unit of GDP, has declined more than half over the last few decades.
In addition to structural changes in the economy, U.S. consumers have been using less gasoline, likely due in part to migration to the cities, public transportation and vehicles offering better fuel economy. Despite population increases, consumption of gasoline has been essentially flat since the mid-2000s after increasing steadily from the post WWII era.
What Else Is Oil Telling Us?
Despite the declining role oil prices play in consumer and business expenses, higher crude oil prices do represent an indirect tax on consumer income which could marginally impact domestic spending capacity and economic growth. With consumer spending propping up the longest economic expansion in U.S. history, rising energy costs could dampen enthusiasm for other purchases. While there are no signs consumer spending has slowed in response to the Saudi disruption, it is early days yet.
Oil price stability following the largest supply disruption in modern history may, in part, be due to declining demand on a global scale as all regions report lower expected demand for oil. Nowhere is dwindling demand more apparent than in China. As China confronts its slowest economic growth in decades and continues to work through trade tensions with the U.S., oil demand is expected to decline by more than half, from around 6 million barrels per day in 2017 to 2.5 million barrels a day in 2023.
While the attack on Saudi Arabia’s oil production facilities was an unprecedented shock to the system, we believe oil prices—constrained by decreasing demand and an economic shift away from manufacturing—will remain stable absent significant supply disruptions in the future.
Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations.
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