Stock Markets Pause for a Long Breath

Public Markets Have Offered Relatively Meager Returns in 2018…

A look at aggregate equity indices shows that Q2 was, as they say, unexceptional. Stocks are essentially flat as we turn toward the second half of the year, clearly taking a breath after last year’s significant gains. Bonds are nursing small losses in 2018, dragged lower by rising interest rates. For the second consecutive quarter, the environment was more productive in areas which lie outside the realm of public stock and bond markets.

…But Still Waters Often Run Deep

Three Significant Developments Occurred Beneath the Surface, However:

1. The U.S. dollar bottomed in April—after several months of steady declines—and then began to rally against all currencies.
2. In the bond market, the amount by which the 10-year Treasury bond exceeded its 2-year equivalent dropped below 50 basis points. Many see this as a reliable signal that the yield curve will invert in the coming months, heralding future economic weakness.
3. Markets became increasingly concerned that the Trump administration’s policy on international trade may devolve from heated rhetoric and negotiating tactics into a retaliatory and destabilizing global “trade war.”

The Greatest Risks Are Monetary and Trade Policy Mistakes

Currency and bond markets are sending a message that the Federal Reserve (Fed) may be setting too aggressive a course for tightening monetary policy, which may bring this long period of economic and stock market expansion to a premature end. Calibrating monetary policy is always difficult, and there is the risk of an unintended “policy mistake” caused by raising interest rates too quickly. Simply put, there are many things the Fed cannot control.

Data confirms that the Trump administration’s pro-growth cocktail of deregulation and fiscal policy stimulus has had its desired effect. The Tax Cut and Jobs Act of 2017 was specifically designed to increase investment and productivity growth, thus allowing the current economic expansion to continue at a sustained higher rate. Many mid-year measures confirm that companies have increased their capital expenditures, with some forecasting a 10% year-over-year gain for the manufacturing sector in 2018.[1] Second quarter U.S. GDP growth is expected to exceed 3%, boosted by activity in both manufacturing and services. This, coupled with recent Fed statements, has led bond markets to price in the possibility of three interest rate increases—though the Fed has only signaled two—before the end of the year, despite the fact that inflation is only now beginning to track more closely to the Fed’s stated target of 2%.

Trade policy continues to prove challenging, as negotiations with China and the European Union took a turn for the worse during the second quarter, devolving from heated rhetoric and symbolic gestures to unabashed protectionist overtones. History shows that if this spirals into a full-blown international “trade war,” higher inflation and lower economic growth could result, especially given the integrated supply chains supporting today’s global economic production. So far, the cumulative effects of announced tariffs are estimated at $120 billion—an amount dwarfed by the estimated $800 billion of fiscal policy stimulus in 2018.[2] Ahead of November’s mid-term elections (which are always difficult for new administrations to navigate), the Trump Administration’s bark has been greater than its bite, but this could change quickly if other countries escalate their retaliatory measures.

[1] Source: Spring 2018 Semiannual Economic Forecast, Institute for Supply Management®

[2] Source: Strategas Research Partners