During 1Q2019 the markets recovered from the fear of recession, resolution of the government shutdown and benefited from the Fed’s pause to its policy tightening. There are still a few major challenges namely, the growing budget deficit, protracted trade tariff concerns, and prospects for slower economic growth in 2019.
US economic data remained mixed as the impact of the government shutdown has been distorting the data. The weak retail sales report for February was offset by favorable employment data.
Economic growth was supported by a strong labor market, tax cuts and fiscal stimulus that kept the economy steady. Growth may have peaked although economic data still appears positive and the labor market keeps adding jobs.
Inflation
Inflation is unlikely to increase in 2019. There are growing signs of an easing in inflation pressures across core consumer prices, producer prices, commodities, labor and the growth of money supply and credit. In an environment where the market is already concerned about the limited policy options available to central banks, a further deterioration in inflation expectations in Japan and the Euro area raises the risk that deflation could return to be a market concern.
In contrast to previous cycles, inflation has remained very stable, and has even drifted down so far in 2019. In February, the overall consumer price index rose by 1.5%, while CPI excluding food and energy was up by 2.1% year-over-year. Headline PCE, the Federal Reserve’s preferred inflation measure, and core PCE both remain below 2%. The main difference between the two measures of CPI comes from the behavior of energy prices, which surged and then retreated over the past year.
Despite a sizable rebound in oil prices since they bottomed late last year, headline CPI is yet to pick up again. Barring any shocks, oil prices should be relatively unchanged in 2019. This, in combination with slower-growing U.S. and global economies, should keep overall inflation subdued this year.
Unemployment
Payroll employment may slow in 2019 as the labor market continues to tighten. As Americans reenter this very strong job market, tight immigration restrictions will limit labor force growth but should also cut the unemployment rate to its lowest level since the 1950s. In recent months, there has been wage growth acceleration with the tight labor market. Wages for production and non-supervisory workers rose 3.5% year-over-year in February.
After a lackluster performance in February, the job market bounced back in March. February’s number of new jobs was also revised upward to 33,000 from 20,000. The US economy added 312,000 jobs in March 2019. The unemployment rate remained at 3.8% in March.
But concerns are mounting about how long that strength can continue. Data from the payroll processing firm ADP showed the number of factory workers falling in March. Major automobile manufacturers have been cutting job. American manufacturers are being battered from multiple sides. Tariffs are driving up their costs, Slower growth in China and Europe impeding demand for their exports. The 2017 tax cuts and government spending increases pumped up growth last year. Those tax cuts are waning in 2019.
Consumer Spending
U.S. consumer spending rebounded less than expected in January and incomes rose modestly in February, suggesting the economy was fast losing momentum after growth slowed in 4Q2018.
The Commerce Department reported consumer spending that is over 65% of U.S. economic activity, edged up a meager 0.1% as households cut back on motor vehicle purchases. Data for December data was revised down so consumer spending fell 0.6%.
Economists polled by Reuters expected weak consumer spending in 1Q2019. The release of the January consumer spending figures was delayed by a five-week partial shutdown of the federal government that ended on January 25, 2019.
The weak consumer spending report added to the soft data on housing starts and manufacturing that indicated a sharp slowdown in economic growth early in the first quarter. Spending on goods and outlays for services fell during the quarter.
Personal income has been volatile in recent months because of one-off factors, including government payments to farmers impacted by the US-China trade war. Wages are gradually rising. Although savings fell during the quarter.
GDP
Gross domestic product forecasts for the first quarter are as low as a 0.9 % annualized rate. The economy grew at a 2.2 % pace in 4Q2018.
The US economic outlook is being overshadowed by slowing global growth, US trade war with China and uncertainty over Britain’s potentially messy departure from the European Union.
Federal Reserve
Rising economic headwinds, benign inflation and rising geopolitical risks contributed to the Federal Reserve’s decision in March to pause its 3-year-old tightening monetary policy. The Federal Reserve decided to stop its projected rate hikes for 2019.
In the FOMC minutes of the March 2019 meeting the Fed signaled greater conviction that Fed officials would not raise interest rates in 2019. The FOMC held the target range of the federal funds rate at 2.25% to 2.5%.
Federal Reserve Chairman Powell signaled on March 20, 2019 that there will be a prolonged Fed pause in raising rates as global risks weigh on the economic outlook and inflation remains stubbornly muted. Low inflation and weak global pricing pressures are challenging the Fed. Powell cited global risks from abroad including trade disputes, slowing growth in China and Europe, and possible spillovers from Britain’s exit from the European Union.
The Federal Reserve announced in March that its current practice of allowing up to $50 billion of Treasuries and mortgage-backed securities (MBS) to roll off its balance sheet each month will come to an end if the economy evolves “about as expected.” The announcement sets an end-date of September 2019 to a programmatic reduction in the balance sheet that started in October 2017. The central bank stated that it will begin in May 2019 to taper the amount of proceeds it allows to roll off each month. Under the current program, it is allowing $30 billion in Treasury proceeds plus $20 billion from mortgage-backed securities to roll off, while reinvesting the rest.
The amount for Treasuries will drop to $15 billion in May 2019. While technically still allowing the proceeds to roll off from mortgages, the Fed will simply reinvest them in Treasuries.
When completed the Fed would still likely have at least $3.5 trillion in bonds, more than four times the roughly $800 billion it had heading into the financial crisis over a decade ago. The Fed currently holds about $3.8 trillion in bonds, down from a high of $4.2 trillion in assets.
Some market experts now believe that there may even be a rate cut in late 2019.
The Fed indicated that it does not expect any meaningful, lasting growth impact from the 2017 tax reforms. The tax cut enacted in late 2017 has begun to fade. Without any new tax cuts and with the dragging effect of trade uncertainty and the government shutdown, overall GDP growth is likely to revert to 2%. The US economy is expected to be able to avoid recession and sustain moderate economic growth into 2020.
The Fed lowered its GDP growth outlook for 2019 from 2.5% to 2.3%. Fed Chair Jerome Powell emphasized that the policy would be driven by incoming data and that it would remain patient and flexible in view of new information.
Central Banks
Central banks are exhibiting flexibility in an uncertain environment. Global central banks remain alert to changing economic conditions. Global macroeconomic weakness heightened at quarter end, 1Q2019, as the Brexit gridlock continued. Additionally, signs of economic weakening in Germany and China economic data was disappointing. The slower growth in China has contributed to weakness in Europe and Asia. Another cause of economic weakness has been the ongoing trade and tariff disputes that continue to weigh heavily on global trade and depress business sentiment. Europe is also vulnerable to renewed political volatility, most likely stemming from Italy.
Low inflation expectations are the reason for the pause by the Fed and European Central Bank (ECB) this year. Economists expect the Fed and ECB to maintain their policy unchanged until upward inflationary pressures emerge.
European growth peaked in 2018 and has reverted to its longer-term trend growth level of 1% to 1.5%. The slowdown has occurred more quickly than consensus forecasts suggested and that has raised concerns that a bigger downturn may be underway. Italy, which is technically in recession, remains the biggest risk for the European outlook although near-term risks have declined.
European monetary policy appears very similar to that of Japan. The ECB has been unable to achieve its goal of raising inflation despite increasingly accommodative policy steps, the central bank appears to be out of additional monetary tools. The ECB reduced its growth and inflation forecasts at the March 2019 meeting and extended the timeline to remain on hold into 2020.
The People’s Bank of China (PBOC) has been normalizing its monetary policy. The Chinese central bank responded to slowing economic growth in China by cutting the reserve ratio requirement by 1 % for all banks in January 2019 intended to shore up lending and growth in China. China has taken a series of policy support steps to curtail the downward momentum in its economy, which has helped ease the external pressures on Europe and other Asian countries.
China’s economy continues to slow despite the policy response. Unresolved trade disputes are another risk. China is now the biggest swing factor in the global growth outlook. China itself is a large component of global growth, and Europe and emerging Asian economies are heavily exposed to Chinese demand. The US is more insulated.
China’s economy may stabilize as the policy steps taken so far begin to support high-frequency indicators of growth in 2Q2019. China’s policy response has been reactive and incremental. For China credit easing has less impact when compared to prior efforts of policy support and may take longer to affect growth now that the economy is more levered.
Trade Tensions
The market had anticipated a US-China trade deal in the next few months until the Administration started expanding tariff threats to the EU. Unresolved trade disputes are a key risk for China specifically and for markets sensitive to changes in Chinese demand such as the EU and some Asian economies.
US and China were motivated to reach a deal on trade but may be delayed with the risk of escalation in auto tariffs between the US and other large auto-producing countries.
The risk scenario of a trade war has essentially materialized and that has had significant spillover effects on global trade activity business confidence and capital spending.
The pace of the global expansion has steadily slowed for the past year. Among developed countries, Europe continues to limp along after political turmoil in France and Italy, manufacturing weakness in Germany in the auto and petrochemicals industries, and the protracted Brexit. The Eurozone, Japan, Korea, and Taiwan have also been caught in the trade tensions cross-fire between the U.S. and China, causing a fall in global trade and a deterioration in manufacturing activity. A general China slowdown has had ripple effects on both developed and emerging market economies alike. Until trade tensions are resolved and Chinese growth stabilizes, slowdown in global growth is likely to continue.
Treasury Yield Curve
On March 22, 2019 the Treasury yield curve inverted. The US Treasury yield curve inverted as measured by the spread between the 10-year Treasury note and 3-month Treasury bill. By the end of the month, the inversion had reversed, even as the 10-year US Treasury yield declined 30 basis points to 2.42%.
Investment Grade Corporates
Credit spreads tightened during 1Q2019 after having widened sharply during 4Q2018 when the market sold off equities and credit bonds. Fears of a recession and credit deterioration caused bond holders to flee to US government securities.
Most of the rally came in January 2019 after the Federal Reserve Chairman Powell reversed his December 2018 stance and now indicated that the Fed would take a more patient and cautious approach to further tightening. Overall, spreads ended 1Q2019 near their long-term averages. Fundamentals remain generally positive while leverage appears elevated and profits are close to peaking as the impact of the 2017 tax reforms fade.
Weak growth, modest inflation, and the Federal Reserve’s dovish shift fueled a rally in bonds and decline in bond yields. Lower interest rates, coupled with tighter credit spreads, compressed spreads on most bonds. Profit growth in 2018 was extremely strong but may not be replicated in 2019 which is expected to have single–digit profit growth. Profits this year will pressured by the fading effects of the tax cuts, slightly higher interest costs, higher materials costs and higher wages.
Corporate debt levels are close to record highs as a percentage of revenue and GDP. Many high-quality companies with strong cash flows continue to paydown debt from recent acquisitions. Companies have used the tax cuts for M & A and share repurchase transactions. Corporate borrowing has increased significantly, and the share of BBBs has increased with continued ratings downgrades.
Credit Quality
Spreads on BBB-rated bonds narrowed in 1Q2019 after the spread widening 4Q2018 when investors fled to Treasuries for safety. Spreads are currently compressed and may continue to tight until mid-year.
A cautionary note is that some investment grade corporations that borrowed heavily may not be able to de-leverage should there be an economic slowdown. Fortunately, the fear of an imminent recession in 2019 has dissipated with the Fed’s rate hiking pause which should provide an opportunity for corporations to de-lever.
Asset Backed Securities (ABS)
The spreads on AAA-rated ABS widened slightly in March as a result of higher issuance during the month. ABS still slightly outperformed Treasuries by a few basis points. The Fed’s pause on raising rates and the current low interest rate environment creates an opportunity for stable ABS performance.
Residential Mortgage Backed Securities (RMBS)
RMBS underperformed Treasuries and other credit bonds in March 2019. The continued rally in Treasuries lowered mortgages. A large proportion of outstanding RMBS carry rates that may see increased prepayment speeds over this year as borrowers take refinance at the lower rates.
Commercial Mortgage Backed Securities (CMBS)
Yields on CMBS yield spreads were flat to slightly wider in March. There was significant level of new issuance of CMBS, yet secondary markets performed well. Longer duration and lower quality CMBS generated positive returns. Risks in this sector include increased price volatility as commercial real estate construction continues to grow yet property value growth has been decelerating.