Two Key Forces Impacting Our Midyear Outlook

The strong equity gains seen in early 2019 seemed to defy both signs of slowing global economic growth and ongoing trade tensions between the U.S. and China. Frankly, I didn’t anticipate that the S&P 500 Index or the Nasdaq would be making new highs by May. While concerns returned to trouble investors as the second quarter unfolded, markets, in my view, showed considerable resilience—aided in part by signs that the Federal Reserve and other major global central banks may be shifting to easier monetary policies.  

Against this backdrop, I recently sat down with two of my fellow chief investment officers, Justin Thomson and Mark Vaselkiv, to share our thoughts on where the market is headed in the second half of the year.

Generally, we remain cautiously positive about global economies and financial markets. However, political risks—in particular, escalating trade disputes—could trigger renewed volatility and further impede growth.

To a certain extent, market behavior in the first half of 2019 seemed to reflect two contradictory perceptions:

• Falling bond yields and an inverted U.S. Treasury yield curve—a situation in which longer-term yields move below short-term interest rates—appeared to signal growing economic pessimism. 
• On the other hand, the relatively strong equity gains seen in the U.S. and many emerging markets in the early months of 2019 seemed to suggest hopes for an earnings reacceleration later in the year.

On the positive side, market expectations for monetary policy shifted dramatically in the first half. Investors now lean heavily toward the view that the U.S. Federal Reserve is more likely to cut interest rates rather than raise them further.

On the negative side, hopes for a trade deal between the U.S. and China deteriorated in May, and the White House briefly threatened to impose tariffs on Mexican goods. Trade fears contributed to persistent strength in the U.S. dollar, keeping emerging market (EM) currencies under pressure.

Much depends on a resolution of the trade war and on the emergence of green shoots of improving global economic and earnings growth. If those appear, the U.S. equity market may make new highs; if not, expectations for 2020 clearly will need to come down.

Global Growth Has Slowed, But Recessions Are Unlikely

Concerns about the strength of U.S. and global economic growth returned in the second quarter of 2019 as the stellar U.S. earnings gains seen in 2018 abruptly stalled.

While the consensus earnings forecast is for a reacceleration later in the year, this will depend on improving global growth, particularly outside the U.S. However, the global economic outlook remains subdued:

• Most developed economies are growing below their potential, and earnings momentum has turned negative in both Europe and Japan.
• In the emerging markets, the strong U.S. dollar effectively is a form of monetary tightening—unwelcome in economies still in the early stages of recovery.
• The trade war is having a corrosive effect on business confidence and capital spending, particularly in export-heavy economies such as Germany, Japan, Korea, and Taiwan.     

Despite these headwinds, the risks of a U.S. or global economic downturn still appear limited. We do not see any major imbalances that would suggest a recession is imminent or even likely.

The strength of the Chinese economy remains a key variable. Slow growth in late 2018 led Beijing to ease credit and boost spending, but the results may not have been as positive as Chinese policymakers desired. Another round of Chinese stimulus would cause us to reconsider our generally cautious stance on global growth.

Trade War Tops List of Geopolitical Risks

A series of events in May—including fresh tariff hikes by the U.S. and China; U.S. sanctions against Huawei, a major Chinese telecommunications firm; and the White House’s threat to impose tariffs on Mexico—have helped reignite fears of an escalating trade war. Although the U.S. and Mexico reached a deal in June that appeared to avoid tariffs, these and other geopolitical events contributed to a surge in perceived economic policy uncertainty, particularly in China but also in the U.S. and Europe.

A trade deal between the U.S. and China is still within reach, but neither country may feel a need to compromise quickly:

• With the current administration facing reelection in 2020, the White House may put off any agreement until next year.
• Political incentives also might favor delay on the Chinese side. Denying the U.S. a trade success could damage the current administration’s reelection prospects, allowing Beijing to negotiate with President Trump’s successor.
• The trade war is metastasizing into a technology war. This could make settlement harder, as both countries may believe that critical technology advantages are at stake.

While the direct impact of tariffs on economics and earnings growth appears manageable at the moment, the secondary effects on business confidence, capital spending, and hiring could diminish hopes for a second-half earnings rebound.

Trade may be the most significant political risk facing investors, but it’s not the only one. Recent elections in Europe have shown that populist anger remains a potent political force. Europe’s moderate political parties took a drubbing in European Union parliamentary elections in May, an outcome that could encourage Italy’s populist coalition to continue ignoring eurozone debt limits. In the UK, a heated leadership contest following Prime Minister Theresa May’s resignation could intensify pressure for a “no deal” Brexit, with major negative implications for the UK and European economies.

Growth Fears Will Pressure the Fed 

The first half of 2019 ushered in a dramatic shift in market expectations for Fed policy. By late May, futures markets were pricing in as many as three Fed rate cuts by the end of 2020.

A deepening inversion in the U.S. Treasury yield curve signals growing market confidence that the Fed’s next policy move will be downward. But with policy rates still at historically low levels and the 10-year Treasury note yielding less than 2.20% at the end of May, Fed policymakers have limited room to maneuver.

We would not be surprised to see a 25-basis point (0.25%) cut at some point later in the year to try to calm down the current volatility. On the other hand, if the Fed goes with a 50-basis point cut, it might spook the market by suggesting that conditions are worse than anticipated.

If the Fed has limited room to cut rates, the European Central Bank (ECB) and the Bank of Japan (BoJ) appear to have virtually none. The ECB’s overnight deposit rate already is negative, while the BoJ is continuing to hold interest rates out to 10 years effectively at zero. While such a stance is highly stimulative, it also means that the two central banks have effectively “run out of bullets.”

Secular Disruption: Incumbents Fight Back

Technological innovation, changing consumer preferences, and revolutionary new business models continue to disrupt established industries. This process has contributed to a stark disparity in the fortunes of the growth and value equity styles.

Nothing in the first half of 2019 suggested that disruption is slowing down. However, the narrative may have shifted:

• Investors appear more aware of the risks in financing business plans that push profitability into the distant future. This could be seen in weak demand for the initial public offerings of Uber and Lyft, the two leading ride-share companies. 
• Established firms are using their financial strength and brand positions to fight back. For example, Disney recently announced major investments in its own streaming video service to compete with Netflix.

Political attitudes toward the major technology platform companies also are changing, due to rising concerns about market power, data privacy, and false or misleading content. Such complaints have not yet generated serious legislative efforts to restrict the major technology platforms, but the issue bears watching.

What We Are Watching Next

Positive economic growth, low inflation, and accommodative monetary policies should support financial asset prices in the second half of 2019. However, the escalating trade war creates substantial risks.      

For U.S. equities, much depends on whether earnings growth resumes later in the year. But if trade uncertainty drags down sentiment, it is difficult to see many catalyst that could mitigate those negative effects. The outlook for international equities also is tied to earnings, but second-half prospects appear weak. Save for stronger stimulus from China, the earnings impulse will remain negative. 

For bond investors, slow but positive economic growth, limited inflation pressures, and friendly central banks should create a supportive environment in the second half. However, trade tensions and U. S. dollar strength suggest a relatively cautious approach to EM debt. At this point in the cycle, perhaps U.S. high yield should also be considered a bit more defensive.

Overall, both the economic environment and corporate fundamentals remain supportive for financial assets. While global growth has slowed, we don’t see any major imbalances that would suggest that a recession is eminent or even likely. The U.S. job market is in very good shape with unemployment at historic lows. Yet there’s still very little inflation.

We believe most investors benefit from maintaining a strategic investing approach and avoiding large or sudden portfolio changes driven by shorter-term trends—whether positive or negative. However, this also could be a good time to have a selective “shopping list” ready in case the markets offer up attractive buying opportunities.

If you would like to gain more insights on our perspective, please view our webcast

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