Three Key Thoughts:

US Economy Grows; Rest of World Slows
Rates Move Lower Still
Trade, Trade, Trade

US Economy Grows; Rest of World Slows

While we haven’t seen an official estimate of US growth for the second quarter of 2019, we think it is very likely to show a continuation of solid, if somewhat slower, growth. At least as importantly, inflation has remained muted, with wage gains consistently in the 3% area. This is good but not a sign that broader inflation pressures are sufficient to get to the Federal Reserve’s 2% target.

As we discussed last quarter, the Fed has shifted its stance toward supporting growth, which it too believes may be weakening. The markets believe that the Fed will cut short term rates a couple of times before 2019 is over, leading the stock market to new all time highs and bond yields to multi-year lows. This has led to a short-term conundrum where bad news on the economy means more rate cuts, which are good for the markets. This likely won’t stay the case for long – either bad news becomes worse (with the economy and the markets turning sharply lower) or it turns to better news (and we keep the economy and the markets rolling on).

Meanwhile, Europe is back in a slowdown, mired down with changes in the European bureaucracy following the elections, an unresolved Brexit and the German growth engine stalling. The European Central Bank believes it has the tools to re-ignite growth and inflation but there is little to show for their efforts so far.

Uncertainty over trade policy with the US is definitely a headwind in China, which ripples across Asia. The Chinese government is trying targeted stimulus efforts to offset the impact of trade-induced weakness but the Xi administration doesn’t have a great record when it comes to economic policy decisions.

Rates Move Lower Still

The first half of 2019 was a rare period in which US stocks reached new highs and bonds of all types rallied right beside them. The yield on the 10 year US Treasury bond dropped to 2% before leveling off – a very sharp drop from the 3.3% we saw just nine months ago. We believe there are three factors that led to this decline: (1) inflation is low and expectations are that it will stay low, despite a tight labor market; (2) the US economy is likely to weaken from its 2018 growth rate as the initial effects of the tax cuts wear off; and (3) US yields look positively rich compared to yields on sovereign debt issued by other developed countries.

We don’t know which of these three factors is the most dominant but we expect they will all stay in place for the near term. We are more concerned about the very narrow spreads on lower quality corporate debt, which could expand rapidly if the US economy slows more than expected.

Trade, Trade, Trade

Several quarters ago, we raised the concern that, having achieved its tax cut goal, the Trump administration would move onto trade policy, where things might get unpredictable. That unpredictability has become a hallmark of US trade policy, making it extremely difficult to discern where we are headed next. The US/China trade relationship is the most important because of its worldwide impact. Despite both Presidents Trump and Xi needing to get a trade deal done for their own political reasons, the need for a “win” by both sides has made real progress elusive. It is entirely possible that the current tariff situation drags on for some time.

Also left undone are new trade deals with the UK (post-Brexit) and the European Union. So far, threats of more egregious tariffs against the EU have not come to fruition. Unfortunately, we have also seen this administration use tariff threats for other purposes, which we believe adds to our reputation for unpredictability. The US and Chinese economies seems robust enough for now to withstand these tariff spats. Europe’s economy hardly needs another source of uncertainty.

Investment Approach

From an investment perspective, we have largely held asset allocation steady, with a modest overweight to US large cap and a substantial – but less than market – weight in international stocks. We remain underweight in longer term fixed income, with an offsetting overweight in hedged equity strategies. In lieu of holding low yielding cash, we have added significantly to short term bond funds or exchange traded funds, which deliver an attractive yield and lower risk of market value changes.