Economists are fond of saying that expansions do not die of old age; they must be killed. As the U.S. enters its 121st month of expansion, the longest on record, and valuations are lofty across most markets, the eventuality and timing of a U.S. recession remain forefront on investors’ minds. In its most recent meeting, the Fed announced a relatively new policy objective—to “sustain the expansion”—and U.S. Treasury and stock markets rejoiced in tandem. Equity indices approached record highs, and the 10-year U.S. Treasury yield hit a multi-year low.
Outside of the U.S., global growth continued to decelerate but remained positive; central banks generally expressed a willingness to engage in further stimulus measures as needed. A persistent lack of inflation, at least according to traditional measures, remains a conundrum and a key challenge for banks around the world. Away from data, trade talks with several countries are fluid; a no-deal Brexit this October is no longer a remote possibility; and tensions with Iran are mounting. All of these issues, added to the distractions associated with the 2020 election in the U.S., pose additional variables for investors to untangle.
The U.S. economic picture continues to be mixed. A strong labor market and rising personal income have supported consumer spending, which accounts for roughly 70% of GDP. First quarter 2019 real GDP was +3.1% (y-o-y), though this figure is expected to slow. And unemployment hovers at a five-year low at 3.6%, although wage growth, as measured by private sector average hourly earnings, remains sluggish (+3.1% y-o-y in May). Meanwhile, manufacturing continues to be a point of weakness; the June Purchasing Managers’ Index continued to signal expansion (above 50), but only barely so with a reading of 51.7, which is sharply off its August 2018 peak of 60.8. And as noted above, Inflation remains elusive with the headline Consumer Price Index (CPI) up 1.8% in May (y-o-y) and Core (excluding food and energy) up 2.0%. The Fed’s preferred inflation gauge, the Core PCE Deflator, is still falling short of its 2% target and rose only 1.6% over the trailing year.
The Fed left rates on hold at its June meeting, but comments from Chairman Jerome Powell were interpreted to be dovish and indicated that cuts would be imminent. As of quarter-end, markets had priced in a 100% probability of a rate cut in July, and the probability of three additional 25 basis-point cuts in 2019 was greater than 50%. But there appears to be room for disappointment if economic data releases do not justify these moves.
Overseas, European Central Bank (ECB) President Mario Draghi also emboldened investors with his comments that rates could be cut and/or asset purchase programs restarted if inflation does not reach the bank’s target. Following those remarks, the German 10-year government bond yield hit a new record low and continued to trend lower into quarter-end, closing the quarter at -0.33%. (The policy rate remained unchanged at -0.40%.) Inflation in the euro zone was +1.2% (y-o-y) in May, and hit the lowest monthly rate since April 2018. GDP was barely positive in the euro zone (+1.2% y-o-y), and while first quarter GDP for Japan (+2.2% annualized) beat expectations, growth is expected to slow for the export-driven country. Inflation continues to be almost non-existent in Japan; +0.8% y-o-y in May. As in the U.S., manufacturing remained a key source of weakness in Europe and Asia, with trade tariffs and tepid global demand being key drivers.
With a torrid start to the year for broad asset classes following an almost equally disappointing end to 2018, more periodic bouts of volatility seem inevitable. Central bank policies that portend lower rates have fueled gains in bonds and stocks globally, but much optimism in the way of stimulus has been priced into asset prices. Valuations are lofty, the certainty and timing of a U.S. recession are unknown, and numerous geopolitical events continue to loom. Thus, just as we have stated in the past, adherence to an appropriate and well-defined long-term asset allocation policy remains the best course of action to manage the path to successful attainment of long-term investment goals.
