At present, the equity market and bond market seem to be telling very different stories about the state of the global economy and prospects for investors. We need to understand both of them as part of building a robust global portfolio.
The US stock market, now back at a record high, could lead investors to conclude that economic growth will continue.
Telling this story:
- Global growth prospects are healthy: US growth is close to trend, and though China's economy is slowing it should be supported by policy stimulus and its depreciating currency.
- Monetary policy remains accommodative: The Federal Reserve has shifted to a "patient" stance with regard to its interest rate policy and has opened the door for rate cuts, the European Central Bank has raised the prospects of further rate cuts, and we expect the People's Bank of China to continue easing policy.
- Full blown trade war will likely be averted: While we do not expect much progress in trade talks at the G20 meeting, we believe high-level talks will continue and escalation will be avoided.
The bond market, now pricing in interest rate cuts over the next 6 months by the Federal Reserve, could lead investors to conclude an economic slowdown is coming.
Telling this story:
- "Soft" and "hard" economic data are weakening: Manufacturing data has softened in the US, Eurozone, and China. Meanwhile, Chinese industrial production growth in May slowed to its lowest rate of growth since early 2002.
- Inflation and inflation expectations have dropped: The Fed’s preferred inflation measure, the core personal consumption expenditure (PCE) price index, has fallen significantly below the central bank's 2% target.
- Trade breakdown still possible: President Trump’s quick deal with Mexico could be seen as validating the effectiveness of hardball negotiating tactics and could increase the risk of a breakdown in US/China trade talks.
Putting the equity and bond market stories together
In our view, the only way that the equity and bond market stories can both make sense is if we assume that the bond market is focused less on growth and more on the willingness of the Fed to engage in a pre-emptive strike to forestall the risk of a recession, while equities are telling us that the Fed will, once again, be successful.
With rates close to the zero lower bound and US policymakers less willing than their European counterparts to experiment with sub-zero rates, the Fed might be worried about its ability to act effectively in the midst of a recession. As such, with inflation still low, and inflation expectations falling, the Fed may perceive the cost of shock therapy to forestall a recession as being lower than the potential cost of entering a recession it will be difficult to fight.
The Fed's actions and developments in US–China talks following the G20 summit are likely to be pivotal turning points for markets in the second half of 2019. In our base case, we expect neither a breakthrough on trade at the G20, nor for US to immediately implement another round of tariffs. We expect that, if the US data does not change meaningfully, the Fed is likely to cut rates at the next meeting in order to show a commitment to avoiding recession. But given the uncertainty associated with each, we try to position for divergent potential outcomes. See our preferences tab for more.