Traders work on the floor of the New York Stock Exchange in the borough of New York City, New York, U.S., April 17, 2018. - Reuters
BY most measures the U.S. economy is in excellent health. Yet stocks are sinking, yields on corporate bonds are rising and commodity prices are tumbling—all typical precursors of a slowdown or recession.
The dichotomy is rooted in two unusual features of the world today. First, while the U.S. is surfing a wave of fiscal stimulus, growth in the rest of the world is slowing. That’s undercutting prospects for companies that do business abroad. Second, the Federal Reserve is steadily withdrawing the unprecedented monetary stimulus that buoyed the economy and almost every asset class over the last decade.
The question is whether markets, in adjusting to these new realities, will overreact to the point that they endanger the expansion, on track to become the longest ever next summer. The answer for now appears to be no, but the trends are troubling.
Assessing forward-looking market and economic data, economists at JPMorgan Chase & Co. put the odds of a recession beginning in the next 12 months at around one in three. A year ago, their models put the probability at 8% to 27%.
JPMorgan economist Jesse Edgerton says this partly reflects the stage of the business cycle. Unemployment is low, wage and inflation pressures are building, asset prices and corporate debt are high and the Fed is raising interest rates to prevent the economy from overheating. “On average, expansions haven’t lasted more than a couple of years” under conditions like this, he said.
Right now, the U.S. economy is firing on all cylinders. Economic output rose 3% in the year through the third quarter, the most since 2014. Unemployment has sunk to its lowest since 1969, and the latest indicators—such as consumer confidence and new claims for unemployment insurance—show no signs of trouble. The main reason for these strengths: a tax cut and federal spending boost that juiced business, consumer and government spending.
The picture is quite different outside the U.S. Both the German and Japanese economies shrank in the third quarter, though partly due to one-off factors, and Chinese growth slipped to its lowest in a decade.
Weak global demand is weighing on commodities, including oil, which is also grappling with oversupply. That, plus a strong dollar—which reduces the value of sales earned in foreign currencies—and trade frictions add up to a cloud hanging over companies that do business abroad.
Analysts are marking down profit estimates for companies with the most international exposure much faster than for those focused on the U.S, according to FactSet. The former are expected to rise 9.4% in the fourth quarter, the latter by 16.5%.
These global pressures are hitting while central banks, led by the Fed, are pulling back the monetary medicine administered over the last decade. That included bond buying (called quantitative easing, or QE), zero interest rates and “forward guidance,” telling investors rates would stay low.
The goal was to encourage investors, individuals and companies to shift their cash from bank deposits and government bonds to riskier investments. It worked, elevating property and stock values and loans to highly indebted companies. A new generation of investors, dubbed “QE babies,” has only known markets backstopped by monetary largess.
Those policies are now shifting into reverse. The Fed began to raise short-term interest rates in 2015, and in 2017 it began to shrink its bondholdings. This year, under Fed Chairman Jerome Powell, it has pared back guidance on where rates are headed. The fiscal stimulus, by pushing unemployment even lower (to levels that in the past have led to inflation), has made some Fed officials more determined raise rates.
Meanwhile, the European Central Bank is planning to halt QE at the end of this year, and the Bank of Japan has slowed the pace of its bond buying. According to JPMorgan, global central-bank assets will start shrinking (from a year earlier) by December.
Fed officials say they’re still supporting the economy. The federal-funds rate, a little above 2%, is near zero when adjusted for inflation. Over time that “real” rate has been about 2%.
Moreover, monetary policy works through interest rates plus the knock-on effect on stock, bond and currency markets and lending. Taken together, these financial conditions have actually loosened since 2015, according to Tobias Adrian, financial counselor at the International Monetary Fund. They tightened during the Fed’s last three rate-hike cycles.
He worries that financial conditions, having been slow to adjust to Fed rate increases, may do so abruptly: “There might be a delayed reaction.”
Jason Thomas, chief economist at private-equity manager Carlyle Group, says even in a slow-growth world, most assets looked attractive when the alternative return on cash was zero. Now investments that are almost as safe as cash yield up to 2.75%. Everything else “looks much riskier by comparison,” he said.
He cites General Electric as an example: “People who owned that stock knew nothing about it. They only owned it for the dividend yield.” When GE slashed that yield to nearly zero, investors fled. Housing has slumped because with mortgage rates around 5% and less tax deductibility, a home is a less compelling investment.
The market isn’t the economy and Fed officials, who are expected to raise rates again next month, are unlikely to change course unless the recent turmoil is mirrored in economic data. Jan Hatzius, chief economist at Goldman Sachs, thinks that turmoil might knock a quarter of a percentage point off growth next year.
But others think the Fed needs to pause and consider that the asset markets are signaling bigger problems than the economic data are now showing. As the Fed well knows, it can raise rates as much as it wishes if inflation turns out to be a problem; it has limited room to cut if the economy is in bigger trouble than it thinks. - WSJ
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