DECEMBER 2018

The Federal Reserve, China, and Recession Risk: A Look at What’s Impacting the Markets at Year-End

Category: Portfolio Management

 By Doug Cohen, Managing Director, Portfolio Management

As we near the close of 2018, it’s hard to ignore the juxtaposition from 2017, when the capital market environment experienced a broad increase in most asset classes, accompanied by remarkably low volatility. Fast forward to the present and, according to Deutsche Bank, nearly 90% of the 71 asset classes they track were down as of the end of October—the worst breadth since the 1905 start of the data series. Even with the recent modest late November/early December rally, 2018 is on pace to post the first down year for both global equities and the Barclay’s Aggregate Bond Index in the last 25 years.

As we approach 2019, here are three things we are monitoring most closely:

The Federal Reserve — “Don’t fight the Fed” has probably been the dominant feature of financial markets since the 2008 Financial Crisis era. That’s been particularly true since former Chairman Bernanke penned his rather remarkable op-ed in the Washington Post in early 2010 stating that a primary goal of Fed policy would be to boost the stock market to help stimulate a wealth effect. Extraordinarily low interest rates both in the US and throughout much of the world helped to do just that amidst unprecedented monetary stimulus.

Of course, Quantitative Easing has now morphed into Quantitative Tightening in the US, with other countries potentially not far behind. After several false starts (e.g., QE1 morphing into QE2 and then QE3), the US has made notable progress in starting the inevitable tightening process with six rate hikes in the last two years, along with the beginning of the long-awaited reduction in the Fed balance sheet earlier this year. The Fed has generally avoided any sudden surprises in appreciation of the still-tenuous state of global markets—hence the strong reaction to Powell’s seemingly off-the-cuff statement during a PBS interview on October 3 that rates were “far from normal, probably” (and the dramatic positive response to his reversal on November 28 when he stated that rates were “just below” neutral).

We are hard-pressed to see sustained inflation pressures in the economy, a view that has likely been reinforced in the near-term by a steep decline in crude and other commodity prices. While the Fed governor “dot plots” currently call for four 25 basis point rate hikes by the end of 2019, we expect no more than two, including one this December. There are other overarching characteristics that we believe argue for a more dovish Fed posture, including the fact that non-financial corporate debt stands at near a post-WWII high of over 45% of GDP and covenant-lite loans account for ~80% of new loans arranged by non-bank lenders—more than double the 2007 level of 30%.

China/Trade Tensions — The best news on the trade front is that unlike earlier in the year when trade uncertainty included the EU, Canada, Mexico, Japan, South Korea, and others, the concerns have now been largely ring fenced to China (yes, there is some risk that tensions resurface in at least some of those other locales if tentative agreements are not ratified). Of course, the more concerning news as President Trump went to Argentina for last weekend’s G20 summit was that the US and China remained at loggerheads. While President Trump’s public views on several issues have changed over the course of the last several decades, he has been steadfast in his belief that China has been among the countries that have taken advantage of the US in trade and intellectual property theft.

Our initial take is that the Trump/Xi talks went about as well as one could have realistically hoped in that the two leaders seem to share a desire to reach some form of accommodation. A cease fire clearly beats escalation into a full-blown trade war. Still, a 90-day “cooling off” period does not buy much additional time before harder decisions will have to be made. Moreover, it is still unclear exactly what tentative understandings may or may not have been reached at the summit given the inconsistent statements issued from both the US and Chinese sides.

What is clear is that the talks come at a critical time for global economic growth given the slowdown in China this year and the escalating fears of a so-called Chinese hard landing. It is probably a bit of hyperbole to say that a failure to bridge the US/China divide would result in some form of mutually assured economic destruction, but the incentives are certainly there for the two sides to eventually reach an agreement. The US is highly unlikely to get the kind of intellectual property reforms it desires. Moreover, we highly doubt that China will significantly curb the key elements of the high profile “Made in China 2025” policy. However, increased Chinese imports of US goods (with lower tariffs) and some degree of enhanced cooperation regarding North Korea strike us as realistic sources of compromise. While this is not a conventional US presidency, US presidents typically turn more “pro-growth” after the midterms and it is certainly possible that GOP losses everywhere but the Senate will encourage President Trump to move back toward “Art of the Deal” mode in early 2019

Recession Risk — In very broad and basic terms, economic slowdown/recession fears matter because they almost inevitably lead to earnings disappointments. Indeed, bear markets are almost always accompanied by recessions (there are rare instances when one could argue that a bear market caused a recession, such as in 2001 following the technology/internet crash). The US is less than a year away from posting the longest period of economic expansion in its history, even if the magnitude of the expansion has been unexceptional.

At this time, we believe the probability of a US recession in 2019 is low but not insignificant. The New York and Cleveland Fed currently put the risk at 20% and 14%, respectively. This reflects generally robust leading economic indicators, including employment trends, consumer spending, consumer confidence, consumer debt, ISM purchasing manager data, money supply, and business confidence. Other relatively benign indicators at present include wage growth, retail sales, profit margins, and truck shipments.

As always though, there is a proverbial laundry list of factors that bear watching, including some recent signs of stress in credit markets (e.g., the flattening of the yield curve, widening spreads, an abundance of “at risk” BBB debt); the slowing housing market (history says that lightning rarely strikes twice in the sense that the cause of the previous downturn is rarely the cause of the next downturn); European political problems (Italy and Brexit in particular); the stress on various Emerging Markets from a generally robust US dollar; and the recent decline in oil prices (seemingly due more to fears of excess production than to the more concerning macro implications of falling demand).

Of the concerns noted above, we are closely watching the flattening of the yield curve. An inverted yield curve has preceded every modern US recession, although there have also been several “false positives”. Since peaking a few weeks back near 3.25%, bond yields haven’t made much progress and the 2/10 curve has resumed its flattening trajectory (currently at less than 15 basis points, the lowest since 2007).

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