This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here
With the U.S. economy finishing a strong year of solid GDP growth (despite equity markets being in disagreement) investors wonder what the New Year will bring. While the current volatility in equity and fixed income markets suggest 2019 will be a tumultuous year, Zacks economists have a cautiously optimistic outlook.
We acknowledge valid uncertainties around trade wars and rising interest rates. Yet there are solid economic fundamentals across the board. The latter suggests 2019 should see a continuation of a robust economy with a low probability of recession.
Nonetheless, we expect the following three themes to be the critical catalysts -- in terms of how the U.S. economy and risk markets ultimately perform across 2019:
1) Trade: While the trade dispute with China appears to be one big worry on investor’s minds, we do not see (yet!) a high risk of a substantial annual macro slowdown. Trade disputes have a long tradition in the global economy.
Here’s some background: In recent history, one of the institutions founded to address this very topic was the World Trade Organization. The U.S. helped to establish the WTO in 1995, as a neutral party that helps settle tariff disputes between member countries. Since its founding in 1995 to today, the U.S. has been involved in roughly 120 trade disputes, both as a complainant and as a respondent. That sums to 240 total (or roughly 1 per month).
The European Union comes in as a close second with almost 100 as a complainant and 80 as a respondent. The accumulated numbers indicate trade skirmishes are nothing new. They have been part of global trade and will continue to be a part of it.
It is our expectation that delays in negotiations will not be the catalyst to a major annual macro slowdown, but rather a quarterly road bump. However, the risky financial markets are going to sell off, in the face of the uncertainty, regardless.
2) Debt Levels: After almost a decade-long period of low interest rates, U.S. corporate debt has exceeded levels reached prior to the financial crisis in 2008. In 2018, the International Monetary Fund (IMF) warned us that after the Fed raises interest rates, higher borrowing costs will make it increasingly difficult for highly leveraged sectors. Think about energy, utility, and real estate sectors.
However, while borrowing costs are indeed rising slowly, we do not expect the rates to rise exceptionally above current levels. Our, expectation of 1 more rate hike by the Fed in 2019, along with a 10-year yield that clocks in below 3.25% by the end of the year, is not a reason for major concern.
In fact, consult corporate bond yields relative to the 10-year U.S. Treasury yield below. You will note. Even given an increase since the beginning of 2018, this still leaves the spread at historically low levels.
Moody’s Seasoned Baa Corporate Bond yield vs. to yield on 10-Year U.S. Treasury-
The Chicago Fed National Financial Conditions Index (NFCI), depicted next, also supports this impression. Financial conditions are still loose compared to long-term averages.
Chicago Fed National Financial Conditions Index--
Negative values indicate financial conditions that are looser than average.
In fact, the National Financial Conditions index remains close the levels observed prior to the financial crisis. We thus do not see a current potential for a major downturn in the U.S. economy -- due to corporate debt levels, especially in light of continued solid earnings growth. Zacks and consensus expect high single-digit annual earnings growth across 2019.
3) Fed Policy: The big elephant in the room in 2019 is going to be the neutral rate, in our view. We do question the FOMC’s ability to master a slow landing at a normal policy stance.
The Leading Index of Economic Indicators for the United States -- provided by the Federal Reserve Bank of Philadelphia gathers up an indication of current macro conditions.
This comprises a number of variables with a history of predictive power. They include housing permits, unemployment insurance claims, the ISM manufacturing survey, and the 10-year vs. the 3-month U.S. Treasury spread.
The graph (above) indicates the Leading Index indeed showed light signs of weakness in recent months. But it is nowhere near a below 1.0 level observed in previous recessions. It remains to be seen, however, how this Leading Index indicator develops as the Fed continues to tighten monetary policy.
The Fed manages a dual statutory mandate to maintain both low unemployment and stable consumer inflation. Both targets are close to being met.
Some voting members may want to raise Fed Funds rates multiple times in 2019 in order to have the ability to lower rates, in the event of a future weakening U.S. and global economy.
But if the FOMC raises rates in 2019 beyond an unseen ‘neutral’ rate -- Chair Powell states this is close to, but below, 3.0% -- it might contribute to an early weakening of U.S. growth. Economists consider the ephemeral ‘neutral’ rate as the rate that neither stimulates nor restrains the economy. It merely maintains GDP growth at its trend rate.
There is also a major question about the pace of the ongoing Fed balance sheet reduction. If “QE” did indeed reflate stocks, their monthly pace on the balance sheet reduction may have to slow down, in order to accomplish a smoother landing for risk markets. Draghi exited “QE” too early, in our opinion. And Powell is paying for that mistake.
If the Fed successfully accomplishes a stable U.S. growth landing with a correct ‘neutral’ rate, it will then leave rates at that level. In our view, a stable Fed policy rate will provide a notable tailwind to the U.S. economy, as it will remove Fed policy rate uncertainty from the outlook.
The struggle with all of this is how Fed growth estimates deal with the latest steep drop-off in stocks. This likely throws a monkey wrench into the computation of a ‘neutral’ rate, until the S&P 500 finds a bottom and heads higher.