Outlook: Third quarter 2019

Economy

Growth in the U.S. economy continues to moderate from the high levels of 2018 and is reverting toward the long-term trend of two percent. The economy is slowing for a myriad of reasons including the fading impact of last year’s tax reform, the sustained tightening of monetary policy since December of 2015, the trade dispute with China and weakness in some foreign countries. Given the slowing trajectory and the volatility in the equity markets late last year, the Federal Reserve has made a significant pivot in their policy. Their guidance has changed substantially and they have indicated their willingness to lower rates if the economy weakens. In fact, futures markets are pricing in between a 0.75 and 1.00 percent reduction in the target Federal Funds rate by the latter half of 2020. The central bank has also tempered the pace at which it is shrinking its balance sheet. Clearly, they have shifted from a policy of constraining growth to one that is geared to extend the current expansion. 

Inflation

Inflation remains subdued. After peaking at close to 3.0 percent in the summer of 2018, current readings indicate that inflation has fallen and is now below a rate of 2.0 percent. Looking forward, we expect price levels to remain contained given the prevalence of both cyclical and structural drivers. From a cyclical perspective, the slowing pace of economic growth should act as a headwind to inflation. Structural headwinds act as long-term suppressants to higher prices and include factors such as the proliferation of technology and our aging population. 

U.S. Dollar

The U.S. dollar declined modestly last quarter. Our currency has been strong in recent years given the relative strength of our economy. However, the Federal Reserve’s recent pivot to an easing bias coupled with the decline in our economic growth rate resulted in a modest retracement. Looking forward, we expect the dollar to remain close to its recent range, but volatility is likely to increase given the opposing forces of an easing bias by the Federal Reserve and weakness in many foreign economies.    

Asset Class

Cash/Money Market Instruments

One of the headline events of 2019 has been the renewed bias toward easing monetary policy in both the U.S. and abroad that has resulted in a substantial decline in yields. In fact, there is now over $13 trillion of negative yielding debt worldwide. In the U.S., the market forecast for future interest rate movements shifted from an expectation of two hikes during September 2018, to the current outlook of two to three cuts by the end of 2019. The sharp reversal in Federal Reserve policy is reflective of many factors including benign inflation, softening global economic data and concerns over the impact of trade disputes. Given the persistently low inflation, it is possible that the Federal Reserve will cut interest rates as soon as July barring substantial progress in trade negotiations with China.

Intermediate Government/Credit Bonds

In conjunction with lower interest rates on Treasuries, credit spreads have also compressed this year. The amount of additional yield gained form purchasing a single A rated bond has decreased from 1.21 percent on January 2, 2019 to below 1.00 percent at the end of June. Tightening spreads combined with lower yields across the Treasury curve are responsible for lower yields and positive year to date returns for intermediate government/credit bonds. Interest rates as well as credit spreads will continue to be primarily driven by geopolitical events as well as signs of the economy’s strength in this aging business cycle.

Tax-Exempt Municipal Bonds

While much attention has been devoted to the budget policies of the federal government, the credit fundamentals of most state and local governments have continued to strengthen since the Great Recession. With some variations between states, tax collection growth trends have been positive overall. In light of the fact that the broader economy is in the tenth year of expansion, state and local governments have been steadily building their reserves. Of course, there are exceptions and some municipalities have experienced deterioration in their financial condition, so we will continue to be selective with a focus on issuers with favorable demographics, strong reserves and manageable pensions.

U.S. Equity

Better than expected earnings, optimism for a trade deal with China and anticipation of a dramatic shift in policy by the Federal Reserve drove stocks to record levels last quarter. Looking forward, we expect the stock market to continue its upward trajectory, but at a modest pace relative to the first half of the year. As of early July, valuations on equities are slightly above historical norms so we expect earnings to be a primary driver of stock prices in the coming months. Consistent with the recent past, the progression of trade negotiations with China and policy responses by the Federal Reserve are also significant factors that can swing both market fundamentals and sentiment. Accordingly, we will be closely watching developments on those fronts and will make adjustments in our forecast as necessary. 

International Equity

International equities have rallied year-to-date despite softening economic conditions. The drivers are varied and include heightened expectations for central bank stimulus as well as improving trade relations. Looking forward we expect foreign markets to provide mixed results in the near term driven by varying economic growth opportunities across regions, ongoing trade negotiations and the Brexit transition. Given slowing rates of economic growth, monetary policy is increasingly converging towards an easing trajectory with significant stimulus employed in China as well as shifts to an easing bias by both the European Central Bank and Bank of Japan. While the level of economic uncertainty is high in some foreign economies, the valuations on foreign stocks are compelling as they are trading at a substantial discount to U.S. equities. 

Commodity

Consistent with the trend of softer economic growth, cyclical commodities such as oil and industrial metals declined last quarter. In contrast, gold and some agricultural commodities generated strong gains. Looking forward, we continue to expect the slower pace of global growth to act as a headwind to higher commodity prices but acknowledge that a positive resolution to the trade dispute or increased monetary stimulus could result in at least a short-term rally.

Potential Opportunities & Risks

Opportunities

The emergence of new technologies—The convergence of cloud computing, significant increases in computing power and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created a number of investment opportunities centered around long-term themes in which disruptive companies can capture high levels of market share in a relatively short period of time. 

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance and transfers of cash. For example, we are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards. Electronic bill paying services and companies that facilitate cash transfers are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies. 

A shift to easier monetary policy—Central banks have shifted from a tightening bias to a neutral or easing bias which provides support for the equity markets and a continuation of the economic expansion. The Federal Reserve was one of the drivers of the market downturn last year after providing guidance that suggested they would raise rates significantly. Given their recent pivot to an easing bias, futures markets suggest the Federal Funds rate will be 75 to 100 basis points lower by the latter part of summer next year. At the same time, the European Central Bank has announced a program designed to generate more bank lending and China has taken several steps to boost the level of stimulus this year.

Risks

Declining growth rates—Monetary policy has shifted to an easing bias as growth rates for earnings and the economy have moderated this year. However, if the deceleration in growth is too dramatic, asset values may decline as well. 

Trade disputes and rising protectionist sentiment—Trade tensions between the U.S. and China remain high, although there has been notable improvement since the latter part of May. If the dispute is not resolved, tariffs are likely to be a persistent issue, resulting in a significant headwind to the global economic expansion. 

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. If the power of these companies continues to increase, government regulators may place them under greater scrutiny by assessing their privacy policies, acquisition plans and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We continue to monitor events across the Middle East and in the South China Sea.

Debt-related issues—Sovereign debt levels continue to grow throughout much of the world, generating conditions associated with low rates of economic growth. In response to the low growth rates, there has been a meaningful shift in the willingness to use fiscal policy to stimulate these economies. However, if the initiatives are debt-financed, they run the risk of exacerbating the issue and creating more significant problems in the long-term.

Cybersecurity—Cybersecurity has become a significant issue as evidenced by the Equifax data breach as well as persistent attacks on both the international money transfer system, SWIFT, and on systemically important financial institutions. The global cost of cybercrime was recently estimated at $600 billion annually, up 20 percent from 2014.