Written by: Shannon Saccocia, Chief Investment Officer | Boston Private
The threat of a protracted trade war between China and the United States has global markets on edge.
In short
- While July's Fed decision was expected to be the biggest event of the summer, the escalation of tariff talk sent markets roiling in August.
- Creating even further angst in the markets was the flood of capital into the domestic bond market, as negative interest rates outside of the United States have yielded significant demand for Treasuries.
- Efforts to discount the inversion of the yield curve as "different this time" have focused on the strength of the U.S. consumer in particular.
Equity market returns in the month of August were negative on the back of global trade tensions and concerns around the increased likelihood of a recession following the inversion of the yield curve.
With the pullback during the month being primarily one of a move away from risk, it is not surprising that large cap domestic stocks were stronger performers than small cap names, and that emerging markets names came under pressure. With the sharp move in the long end of the yield curve, bonds with greater duration outperformed those in the intermediate part of the curve, while higher quality credit outperformed high yield, which experienced outflows in the month.
From an economic standpoint, U.S. consumer data remains robust. July consumer spending was up +0.6% month-over-month, and retail sales rose +0.7% as inflation posted a +2.2% gain year-over-year. Consumer sentiment is still positive as well, albeit off its recent highs on the threat of greater tariffs on consumer goods. Conversely, the challenges in the manufacturing economy remain, with the flash ISM Manufacturing PMI falling into contraction territory at the 49.1 mark, as producers continue to experience weaker orders on concerns of slowing global growth. This divergence is creating consternation for the Fed, as evidenced by the July minutes which showed a clear lack of consensus around further easing.
Outside of the U.S., the data is less constructive. Eurozone manufacturing remains mired below 50, coming in at 47 for the month of July. Industrial production fell by -1.6% month-over-month, and inflation remains well under target, increasing only +1.0% year-over-year in August. Japanese industrial production, too, only grew by +0.7% year-over-year in the month of July. Accommodation in these economies is the only path for their central banks, with both the Bank of Japan and European Central Bank indicating that they will do what it takes to drive inflation and growth. Data out of China showed some signs of improvement in August, despite the negative headwinds of U.S. tariffs, with manufacturing posting a gain to 50.4 from 49.9 in July. The improvement is likely short-lived if tensions continue to escalate, however, and the pace of growth remains below where the Chinese economy has been for the last several years.
In Focus: Yield Curve Inversion – And Why It Matters
The spread between the 10 Year Treasury Yield and the 2 Year Treasury Yield is one of the most watched indicators in the U.S. economy and much emphasis was placed on its inversion this month, as powerful conclusions regarding the market's assessment of growth, inflation, and future Federal Reserve action can be garnered from this very straight forward, accessible indicator. In fact, a commonly repeated refrain is that "every recession in the past 60 years has been preceded by an inverted yield curve".
So does an inverted yield curve actually predict a recession? Findings from the Federal Reserve Bank of San Francisco suggest that although an inverted yield curve does have some predictive power, the timing of a recession after an inversion is uncertain, varying anywhere from six to 24 months. Accordingly, we can presume that yield curve inversions do not occur in a vacuum, and instead are a commentary on what is happening in the underlying economy. We prefer to say that yield curve inversions "precede recessions rather than predict them", meaning that its use as a recession predictor is limited and other economic indicators are just as relevant.
We want to draw particular attention to this last point. It is important to note that while it is clear that the global economy is softening at large, the U.S. economy remains on track for growth. Recent consumer spending data remains robust, financial and credit conditions remain benign, and consumer and small business confidence has been steady. Ultimately, a strong consumer, any optimism on tariffs, and an increasingly accommodating Federal Reserve should be enough to keep the economic expansion going at least through the end of this year, and into 2020. Stock market gains, too, could persist, as they often do just following an interest rate cut.
What We're Watching
The challenges of navigating changing policy amidst a potential economic slowdown remain foremost in the minds of economists and investors alike.
The narrative around trade tensions has shifted modestly in the last 5 weeks. While there are many who point to the long term benefits of creating better protections in the Chinese market for American goods and particularly for our intellectual property, the number of business organizations that disagree with the proposed framework for tariffs has grown. The timing of the decision to put these tariffs in place is part of the argument; with global growth already low and now slowing, companies and consumers may be less insulated to higher costs. The impact of tariffs on the global economy will be watched carefully in the coming months, as we await talks between the United States and China, now expected to occur in October.
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