Outlook: Fourth quarter 2019

Economy

Growth in the U.S. economy is decelerating and is expected to hover around the 1.5 percent to 2.0 percent range. The current drivers of growth are consumer spending, which has been unusually strong, along with a significant amount of government expenditures. In contrast, manufacturing activity and business investment have been soft and are acting as headwind to the expansion. Notably, the deceleration has been a global phenomenon and central banks around the world have boosted their levels of stimulus. In our country, the Federal Reserve has lowered its target interest rate two times since July 31st and announced it is no longer reducing the size of its balance sheet. Looking forward, the futures markets are currently projecting between one and two more rate cuts by the end of March 2020. Central banks around the world are pursuing similar actions and we have shifted from a period of tightening policy to a global easing cycle. This is a positive development and will help the expansion to continue, but growth will be modest as many of the issues require structural reform and targeted fiscal policies that have yet to gain traction in many countries around the world. 

Inflation

Inflation has stabilized around 1.5 percent to 2.0 percent in recent months after peaking at close to 3.0 percent in the summer of 2018. 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 create 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 increased relative to many currencies last quarter. Weakening growth prospects in foreign economies, central banks actions to lower interest rates and the proliferation of negative interest rates in Europe and Japan have generated strong demand for our currency. Looking forward, we expect the dollar to remain elevated given the relative strength of the U.S. economy.

Asset Class

Cash/Money Market Instruments

Interest rates on cash and money market instruments have steadily declined. After raising rates in December of last year, the Federal Reserve reversed course last quarter with their first rate cut in July and a second reduction in September. Fears of slowing economic growth, and the increasing risk of an eventual recession, remain the primary concerns with several factors including geopolitical issues contributing to heightened anxiety. After the September meeting Federal Reserve Chairman Jerome Powell attempted to temper expectations of future reductions in rates, but the market is confident they will deliver at least one more cut this year.       

In foreign economies, sluggish economic growth, and in some regions, economic contractions, have led to an increase of negative yielding debt to more than $13 trillion worldwide. Given the soft economic conditions, interest rates are likely to remain below zero in those regions for the foreseeable future.

Intermediate Government/Credit Bonds

The difference in yield, or the spread between single A rated corporate bonds relative to U.S. Treasuries, peaked in early January at close to 1.20 percent. Credit spreads tightened through the end of July and currently stand close to the five-year average at 0.99 percent. The impact of geopolitical events, changes in expectations for economic growth and corporate profits will continue to be expressed via credit spreads. Given the current outlook, we expect interest rates and credit spreads to remain range-bound in the coming months.

Tax-Exempt Municipal Bonds

Change in our tax laws, as well as the anticipation of additional rate cuts by the Federal Reserve, continue to attract investors to the municipal bond market. Municipal bond funds and ETFs have seen net inflows every week totaling to $63 billion through August per Investment Company Institute data. Credit fundamentals have been relatively benign, though underfunded pensions are still a concern. The impact of climate change is getting increasing attention as an underestimated risk that local economies will have to address, particularly in areas prone to natural disasters. While this may lead to higher issuance in the future, the near-term outlook calls for yields to remain close to their recent trading range.

U.S. Equity

Better than expected earnings, optimism for a trade deal with China and a global wave of central bank stimulus 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 nine months of the year. As of early October, 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 declined modestly last quarter given slowing global growth and a strong rally in the U.S. dollar. In local currency terms the developed markets generated gains with positive returns in Europe, Asia and Australia. However, the rally in the dollar resulted in losses for U.S. investors in those markets. In contrast, the emerging markets generated modest losses in local currency terms and the declines were broadly based. Looking forward we expect foreign markets to provide mixed results driven by varying economic growth opportunities across regions, ongoing trade negotiations, a strong U.S. dollar and the Brexit transition. 

Commodity

Commodities generally declined last quarter with agriculture, industrial metals and energy prices moving lower. The softening of the global economy impacted cyclical commodities while the trade dispute between the U.S. and China weighed on prices for agricultural goods. In contrast, precious metals such as gold 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 further increases in 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 an easing stance 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. Now central bankers worldwide are rapidly shifting policy in the other direction. Despite two rate cuts last quarter, futures markets suggest the Federal Funds rate will be 75 basis points lower by the latter part of summer next year. At the same time, the European Central Bank and the Bank of Japan are engaged in negative interest rate policies and quantitative easing programs. China has also 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. If the deceleration in growth is too dramatic, asset values may decline as well. 

Trade disputes & rising protectionist sentiment—Trade tensions between the U.S. and China remain high and newly imposed tariffs on European goods have opened a potential new front in the negotiations. If the disputes are 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 has been estimated at $600 billion annually, up 20 percent from 2014.