The equity and credit markets are coping with trade uncertainty remarkably well. This appears to sit in contrast to the government bond market, which paints a considerably bleaker picture of the outlook. Indeed, all assets across the risk spectrum have rallied significantly this year.
Asset class returns
% total return in GBP
Source: FactSet, Barclays, Bloomberg, BofA/Merrill Lynch, FTSE, MSCI, TOPIX, Thomson Reuters Datastream, Standard & Poor’s, J.P. Morgan Securities, US Federal Reserve, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 13 June 2019.
At face value, this looks like the bond and equity markets are out of sync. In fact the circle can be squared: the market is expecting the Federal Reserve (Fed) to pick up the pieces and sustain the US expansion. In global terms, we are learning once again that this expansion needs low interest rates to keep it going; “normal” interest rates are not coming back.
The Fed is certainly under considerable political pressure. The US president has explicitly stated (via Twitter) that the Fed is a deciding factor in whether the US “wins” the trade war. We should be careful about assuming that because the Fed is operationally independent it is necessarily free of political interference. If a narrative builds that the Fed is not a “national champion”, the public could start to question whether it deserves the powers afforded it. If the recovery falters, the Fed will be the fall guy.
There is already enough weakness in the economic data and uncertainty in the outlook to justify a cut. Core inflation as measured by the personal consumption expenditure deflator is soft. Indeed, the Fed is undertaking a review of its framework given the problem of consistently low inflation.
The end result of this may be the Fed aiming for a period of higher inflation in the coming years. The market has already priced almost 3 cuts by year end. Though it seems an extraordinary shift from the 2 hikes priced for 2019 last September, we wouldn’t argue against the idea that these cuts will be delivered.
Federal funds policy rate expectations
% Fed funds rate, FOMC and market expectations
Source: Bloomberg, US Federal Reserve, J.P. Morgan Asset Management. Forecasts are median estimates of Federal Open Market Committee (FOMC) participants. Market expectations are calculated using OIS forwards. Past performance is not a reliable indicator of current and future results. Data as of 13 June 2019.
This is unlikely to prevent the US economy from slowing. Fiscal stimulus is wearing off, and that alone is likely to take a percentage point off growth by the end of the year. Whether the slowdown is more meaningful depends on how US companies respond to the global hostilities. At present, the US household sector is in good shape: its financial situation looks strong compared to history and unemployment is at a near 50-year low.
But if the corporate sector is spooked by the trade agenda and chooses to cut jobs as well as capex, consumer spending could falter. We’ll be watching indicators of employment intentions very closely, but for now expect growth in the US economy and in earnings to experience a period of stagnation rather than meaningful contraction. On the earnings front, it’s worth noting that even stagnation would be well below analysts’ expectations for next year which currently sit at 11% growth for the S&P 500.