Notes on the week aheadContributor Dr. David Kelly
Slowdown is coming
Just over eight years ago, HBO launched its very successful series, “Game of Thrones”, set in the mythical medieval kingdom of Westeros. The first episode was entitled “Winter is Coming” and we were warned that winters in Westeros were particularly harsh and could last for years. In the early episodes, I rather expected to see peasants working feverishly in the fields and erecting great barns to store harvests However, this was not the case and the focus throughout the last eight years has instead been on the efforts of the various houses of the kingdom to achieve supremacy through brutality, sorcery, dragons and intrigue. The weather, meanwhile, has been slow to change and the threat of winter has rather faded into the background.
An end to this long economic expansion has similarly been prophesied for years and has failed to materialize. More recently, many, including myself, have argued that, while recession was not imminent, the surge in economic growth in 2018 was temporary and that the pace of economic growth would slow this year.
Earlier this year, it appeared that the slowdown was upon us, and the Federal Reserve paused its interest rate hikes in response. However, numbers due out this week should show continued economic momentum in the first quarter, raising a number of questions:
- Has the slowdown just been postponed for a few months or has it been cancelled?
- Did the Fed blink too quickly at signs of economic weakness, and will they resume rate hikes later this year? and,
- Have investors become too complacent about the prospects for continued mild economic weather?
On the first question, it still looks like the slowdown will occur – just a little later than anticipated a few months ago. This week’s GDP report could show real annualized growth of 2.8% in the first quarter which would translate into a 3.1% year-over-year gain. However, within this number, real inventory growth could exceed $100 billion annualized and getting this number back to a trend pace of $40 billion annualized should be a significant drag on economic growth in the months ahead. In addition, the latest international trade data suggest a sharp decline in the nation’s trade deficit in the first quarter. However, this is also likely to be temporary, given the volatility of global trade data which has been exacerbated by tariff uncertainty.
This week’s numbers on Home Sales should mirror the weakness in last week’s housing starts data while Durable Goods Orders should look uninspiring outside of the volatile transportation sector. Going forward, the lack of any further tax cuts should cause consumer spending and capital spending to grow more slowly in the months ahead following solid gains in 2018.
One apparent signal in the opposite direction has been the remarkably low level of Unemployment Claims in recent weeks. Even if, as we expect, weekly initial claims bounce above 200,000 in this Thursday’s release, the 4-week moving average could still fall to its lowest level since 1969.
However, on this indicator, it is important to recognize two things. First, employment is a lagging economic indicator so that any weakening in the labor market would likely follow rather than precede a slowdown in GDP growth. Second, a lack of available workers may be depressing unemployment claims more than the underlying pace of job growth would suggest. Companies that are having a hard time finding new workers may prefer to reassign rather than fire employees who happen to be working in their less profitable operations.
In short, while trade and inventories should boost first-quarter GDP, there is little reason to expect sustained strength in the second quarter or beyond and year-over-year GDP growth should still slip towards 2% by the third quarter.
On the second question, between September and January, the Federal Reserve pivoted from expecting three hikes in the federal funds rate in 2019 to expecting none.
This change in perspective was understandable given the clear slowdown in global manufacturing, the uncertain effects of the government shutdown, lower oil prices (contributing to lower inflation) and a sharp selloff in the stock market. While they might have remained slightly more hawkish if they had anticipated this year’s strong bounce back in stock prices, the relevant question today is whether policy is in the right place given current economic and market conditions.
On economic growth and inflation, the Fed has reason to feel comfortable. While economic growth didn’t slow noticeably in the first quarter, it seems set to do so in the quarters ahead. Meanwhile, inflation remains relatively benign. While oil prices have rebounded from their lows of late last year, they remain below year-ago levels while the dollar remains higher than a year ago. In addition, despite very tight labor markets, there is little evidence yet of wages outpacing the combined gains in consumer prices and productivity, something that would be required if higher wages were to lead to higher inflation overall.
On asset prices, there may be reason for greater unease. While stock prices remain slightly below last September’s peaks, they have continued to move up since the end of last year. This, combined with rising home prices is continuing to boost the market value of U.S. assets relative to the output of the U.S. economy. Throughout this expansion, low interest rates have generated neither above trend economic growth nor rising inflation. However, they have persistently boosted asset prices and the greatest long-term threat to the expansion is that asset prices rise too far and then, eventually, fall too fast.
While this is a risk, the Federal Reserve now faces a high bar on further changes in monetary policy in either direction. If they were to resume tightening in the face of a slowing economy and quiescent inflation they would undoubtedly generate considerable criticism from politicians – criticism that, in the long run, could threaten Fed independence. If, on the other hand, they were to cut rates, many investors would wonder what it was that had them so concerned, potentially igniting recession psychology. So while, Fed policy-makers have perhaps been a little more dovish than they intended, they will likely stick with current policy for as long as possible.
Which brings us to the third question. A long bull market in stocks, combined with low inflation and a dovish Fed has left both stock and bond valuations at high levels. In the bond market, the real yield on 3-month T-bills is far below historical averages and investors are generally not being paid for taking the duration or credit risks required to boost those yields. Similarly, in U.S. stocks, forward P/E ratios are running a little above their long-term averages. With earnings growing more slowly, long-term equity returns are likely to be muted.
Many investors have accumulated wealth in this long expansion and bull market and can afford to be more conservative going forward. In addition, there should still be ways of augmenting low U.S. stock and bond returns through better stock selection, international diversification and some allocation to alternative assets.
However, in planning from here, it is important to recognize the limits that slow growth and high valuations put on future returns, even in a relatively benign environment. It is also a good time to remember that, in a down market, the most speculative securities will likely take the biggest hit.
I suppose, this being the last season of Game of Thrones, winter will finally arrive. For investors, the timing of a downturn is less certain, but it is just as necessary to be positioned for slower growth and to be prepared just in case it turns out to be something worse.