Three Key Thoughts:

US Growth Scare
Central Banks to the Rescue?
Self-inflicted Wounds

US Growth Scare

Over the past twelve months, long term bond rates have fallen precipitously. After peaking at around 3.2% a year ago, the rate on 10-year Treasury bonds has been cut in half, to around 1.6% at quarter end. While there could be several factors contributing to this sharp decline, the primary culprit would seem to be a foreshadowing of much slower economic growth. The US economy stayed reasonably strong over the first half of the year (2.6% growth) while the rest of the world appeared to be weakening. However, a number of recent indicators have shown signs of a weakening economy.

This is not really surprising. The short-term impact of the 2017 tax cuts has largely worn off so the economy is likely just moving back toward its long-term growth trend rate of 1.5-2.0%. But, in the process of slowing the growth rate so much, there is a bigger chance that we overshoot and end up with a recession (typically defined as two consecutive quarters of negative economic growth).

At this writing, the US stock markets are trying to sort out how real this growth scare is. We went through a similar exercise in the fourth quarter of last year, with the markets declining quite quickly on concerns that a recession was imminent. We expect more volatility ahead as we observe how consumers and businesses react to a slower growth outlook. For now, the consumer is leading the parade. If this continues to be the case, then this growth scare will prove fleeting as well.

Central Banks to the Rescue?

The self-described “data dependent” Federal Reserve will likely reduce interest rates further, in response to the weakness already reported. The target Federal Funds rate peaked at 2.5% for this cycle (so far) and we expect it to be reduced to 1.75% by year end. Unfortunately, by waiting for the date to appear before they act, the Fed will be behind the curve, reducing the potential impact of their actions.

In shifting toward an expansionary policy, the US Fed is joining central banks throughout the world in expanding policies they hope will stimulate growth. In Europe and Japan, the central banks have been at this for a long time with limited success in Japan and virtually no success in Europe. The European Central Bank has targeted negative interest rates now for some time but there is no evidence that this experiment is working to stimulate growth. Given the relatively low rate at which the US Federal Funds rate peaked for this cycle, there is increasing chatter that the US might also enter the negative interest rate world.

Self-Inflicted Wounds

As we have said several times in the past, we believe the trade war narrative initiated by the Trump administration was built on faulty economic premises. So far, the use of tariffs has done nothing but stoke uncertainty both in the business community and in the halls of foreign governments, at a time when more uncertainty is not needed. We already have the unsolved Brexit puzzle, Europe’s bureaucratic quagmire, Japan’s structural problems, the China/Hong Kong strife and Iran trying to create middle east conflict. Here at home, the impact of the tariffs on the prices of imported goods has at least partially offset the benefits of the 2017 tax cuts.

If all that weren’t enough, we now have the President and the House of Representatives engaged in a shooting war over a pending impeachment inquiry. We offer no predictions on the outcome – the best we can say is that both sides want it to end quickly. While this drags on, the dysfunction in D.C. does nothing to help US consumers to feel more optimistic about their futures. Therein lies the concern: that we could develop a negative self-reinforcing cycle that drags us into recession.

On the positive side, consumers are still spending and businesses are still hiring. And, for the most part, they view Washington antics as a side show, not something that affects their daily lives in any significant way.

Investment Implications

Clearly, the best place to have invested for the last twelve months was long term bonds, which surprisingly posted double digit returns. Many other parts of the fixed income markets also had strong returns, beating the returns of stocks, both domestic and foreign. However, having taken these big steps down in yield (and up in price), we view the fixed income markets with a great deal of caution as small absolute moves in yields will have an outsized effect on prices. In addition, yields on lower rated bonds don’t provide a generous cushion, should the economy deteriorate and cause those companies financial stress. On the other hand, should economic data stabilize or improve, we could easily see rates on longer term bonds jump up quickly.

Overall, we have kept asset allocation relatively stable, making modest adjustments in individual positions. For example, we have reduced our dedicated Asia exposure in favor of a global equity fund, a much broader growth mandate. We have not changed our “economic weakness” positioning of lower investments in small cap stocks and high yield bonds, with greater holdings of short term, high quality fixed income funds.