economic perspective

October 2019

  

By Thomas Dillman

With the third quarter of 2019 in the rearview mirror, Mutual of America Capital Management LLC takes a close look at three key issues affecting economic growth in the United States and across the globe.

Through the end of the third quarter, the S&P 500® Index advanced more than 21% on a total-return basis and 19% on a price-only basis (excludes dividends). Similarly, the MSCI World Equity Index increased nearly 16% on a price-only basis. However, the one-year price returns for each index were only 2.2% and -0.2%, respectively. Percent changes are highly dependent on endpoints, or in this case, the specific dates used. The strong percentage performance in 2019 is a stark contrast to the 15% decline during the fourth quarter of 2018. At that time, investors feared the Federal Reserve had gone too far in its program of progressive rate increases, thereby threatening recession. Advances in the markets this year are being fueled by a reversal in Fed policy that has yielded two interest-rate cuts, with the expectation of at least one, if not two, more this year.

What Will the Federal Reserve Do?

One critical issue is whether or not Fed easing (along with monetary easing by most other central banks around the world) can offset a variety of factors weighing on growth globally and domestically, including the trade war between the United States and China, the threat of Britain's economic dislocation from the European Union and the decline in manufacturing indexes of most major economies below the level signaling growth. As discussed in July's Economic Perspective, the stock market seems to believe the Fed can sustain growth, while the bond market remains skeptical.

U.S. vs. China Continues

Regarding the ongoing trade dispute between the U.S. and China, negotiators recently met for the first time since the collapse of talks last spring and the announcement and implementation of new U.S. tariffs on $272 billion worth of Chinese exports beyond the existing tariffs on $250 billion. Tariffs of 15% on the first $112 billion were implemented on September 1, and tariffs on the remaining $160 billion are scheduled to go into effect beginning December 15. In addition, the tariff rate on the $250 billion in effect prior to September was scheduled to be raised from 25% to 30% on October 15, but was suspended as a result of the recent talks in return for the promise by China to purchase American agricultural goods, as well as to have further talks to tackle the more difficult issues. These include structural changes regarding increased access to Chinese financial markets; elimination of current requirements that U.S. companies doing business in China do so through joint ventures with Chinese partners holding a majority interest; and protection of U.S. company trade secrets, patents or copyrights. Whether this trade truce will yield a more substantive deal in the near term is uncertain. In addition to the trade issues with China, the Trump administration is also considering tariffs on European luxury auto imports.

End in Sight for Brexit?

In the United Kingdom, Prime Minister Boris Johnson is committed to the exit of that nation from the European Union, whether or not an agreement for a smooth transition is reached. Given how long the negotiation process is dragging on, many businesses and European organizations based in the U.K. and in Europe have already made adjustments in anticipation of an eventual Brexit, including relocation of all operations to Europe. According to a recent PBS NewsHour report, more than one trillion dollars in assets has already left the United Kingdom.1 While not directly comparable, assets generally generate growth. Nonetheless, at this point, we believe a "hard" Brexit (one without an agreement with the European Union) will be far less dislocating than it would have been two years ago. Furthermore, in our opinion, the end of uncertainty would be a relief for all: businesses, governments, EU administrative organizations, investors and the general population, especially of Europe and the U.K. In recent days, Johnson secured an agreement with the EU on an exit, and the British Parliament agreed to consider it but only after a delay – a partial victory for Johnson. Furthermore, if and when Parliament takes up the current agreement, it is likely to add amendments that would prove unacceptable to the EU. Johnson has called for snap elections on December 12 to pressure Parliament to act on the proposed agreement as it stands. In the meantime, the EU reluctantly agreed to extend the October 31 deadline until January 31, 2020. Furthermore, Parliament rejected Johnson's call for an election. Thus, uncertainty continues.

Deteriorating Global Economic Fundamentals

While the S&P 500 Index and many other stock market indexes continue to flirt with new highs, global economic fundamentals are deteriorating. Outside the U.S., economies have been weakening for some time. For example, German factory orders fell 6.7% on a year-over-year basis, and Germany's economy is the most important driver of European growth. Gross Domestic Product (GDP) growth for the EU overall has steadily eroded over the past 18 months, declining on an average annualized basis from 2.9% in 2017 to 1.5% in 2018 to 1.4% in the first half of 2019. However, GDP growth for the second quarter of 2019 was 0.7% versus 2.0% in the first quarter. For the full-year 2019, growth appears headed for a sub-1% rate. Regarding China, private estimates of GDP growth recently diverged from government estimates in the low- to mid-6% range to a range of 3% to 4%.2 In fact, China's third-quarter GDP was reported as 6.0%, the lowest quarterly annualized rate since 1990. Recent Chinese export numbers showed a year-over-year decline of 1% versus a consensus of 2.2%. A company that uses satellite heat signatures to measure Chinese industrial activity recently reported a significant drop. And another company that tracks online travel searches among residents of China, found a significant 12% drop versus the previous year in the post-New Year's holiday season, possibly suggesting a decline in the number of migrant workers returning to factory jobs.3 Elsewhere in Asia, Japan's GDP growth averaged about 0.6% over the past four quarters, and the government is reported to be considering lowering its current forecast. Despite this weakness, a scheduled hike in the consumption tax rate from 8% to 10% was just implemented and will likely further weaken growth. Finally, the International Monetary Fund (IMF) just cut its forecast for global growth this year to 3.0%, the lowest in the past 10 years.

U.S. Economy Showing Mixed Signals

The U.S. economy has also decelerated during 2019, admittedly from a high level in 2018 and the latter half of 2017 as a result of the Trump administration's late-2016 tax package. While first-quarter GDP did register 3.1% on an annualized basis, it followed a weak 1.1% showing in the fourth quarter of 2018, and was succeeded by a 2.0% report in the second quarter of this year. The latter results were fueled primarily by strong consumer spending and an uptick in government spending. However, in looking at the progression of trailing-four-quarter, year-over-year percentage changes in GDP, the sequence rose steadily from a low of 1.3% in the second quarter of 2016 to a peak of 3.2% in the second quarter of 2018. Then, it proceeded to slow steadily over each of the next four quarters to 2.3% in the second quarter of this year. GDP for the third quarter is currently expected to come in at 2.1% on an annualized basis.

That said, if the U.S. economy resettles around its post-crisis, long-term average of about 2.0%, the expansion could continue for some time. There are significant pockets of strength. Consumer spending remains a standout in terms of levels of growth, despite slowing retail sales in August and an unexpected decline in September. Total consumer expenditures, which subsume most retail sales, have accelerated over the past three years to an annualized rate of 5.2% in 2018 from 3.8% in 2016. Given that consumer spending represents 70% of the U.S. economy, its contribution to domestic economic growth is significant. Strong levels of employment, with a historically low 3.5% unemployment rate, and continued firmness regarding job hires, mean that consumers have ongoing cash flow to sustain spending. Furthermore, the consumer savings rate is at historically high levels, providing a cushion for either continued spending or cautionary balances in case of a downturn. Additionally, lower interest rates buoyed new and existing home sales as well as housing starts and building permits in August. However, incoming housing statistics for September are very weak.

Weak Readings for Global Manufacturing

Global manufacturing weakness is reflected in current readings, as well as the downward trend over the past year in the ISM Manufacturing PMI surveys. These surveys query business purchasing managers monthly to report on various aspects of production, such as orders, shipments and prices, in terms of strength, weakness or no change from the prior month. Of 18 global indexes, 10 are currently below 50, the line of demarcation between growth and contraction.4 Importantly, included in the latter group are the Eurozone, Japan, South Korea, Mexico and the U.S. The average of two separate surveys on China is currently 50.6, although both recently strengthened, albeit modestly. While the downward trend of most global surveys seems to have slowed or even bottomed, the unexpected decline in each of the last two months in the U.S. manufacturing survey below 50 is disturbing investors. Even more disturbing is the decline, into contraction territory, of the U.S. non-manufacturing survey, which covers service industries representing the majority of total U.S. production. There are only three occasions in the post-World War II period when the ISM reading below 50 for the U.S. was not followed by a recession (1961, 1983 and 1994).5

Corporate Earnings Following Suit

The correlation between ISM readings, which are leading indicators of future economic activity and corporate earnings, is historically strong. S&P 500 earnings so far this year are very weak, registering a 0.2% and 0.8% increase, respectively, in the first and second quarters. Consensus estimates for the third quarter, now being reported, stood at a negative 4.2% prior to the beginning of the reporting period. After the first three weeks of reporting, results are coming in a bit ahead of that estimate, but are still tracking at about a negative 2.0% for the third quarter. However, those companies that have given guidance expressed caution about the next quarter. The fourth-quarter consensus earnings estimate for the S&P 500 Index at the beginning of the reporting season was up 3.1%, but estimates have been coming down as third-quarter earnings have been reported. At the current price level of the S&P 500, the multiple is 17.5 times earnings. We believe this is high, given flat year-over-year earnings, widespread evidence of economic weakness and both trade and monetary policy uncertainty, to say nothing of geopolitical unrest. Equity investors appear to expect an upturn in global economic growth in response to easing global monetary policy, especially by the Federal Reserve.

However, the history of the Fed's monetary cycles shows that the end of a tightening cycle, which, in this expansion, occurred in December of last year, followed by easing, was followed by recession in all but one such cycle, in the middle of the expansion in the 1990s. In that instance, the Fed aggressively lowered rates; the current Fed remains divided over if, and by how much, rates should be reduced going forward. The current implied probability of a 25-basis-point cut at the upcoming end-of-October meeting stands at 92%, while that of another 25-basis-point cut in December is 58%.

Return to Fiscal Stimulus?

Many economists argue that it is time for fiscal policy (i.e., government spending) to be increased to further prime the pumps of economic growth, both in the U.S. and abroad. The constraint, especially in the U.S., China and Japan, is the already high debt level of each country, to which incremental fiscal stimulus would only add. Furthermore, fiscal policy is the primary countercyclical tool to contain the worst consequences of recession. The Trump administration tax cuts were designed to boost economic growth, but their effects have largely worn off – except for their ongoing contribution to higher annual deficits and, thus, the national debt. In other words, the fiscal ammunition for this cycle is exhausted. For that reason, monetary policy will have to carry the burden of maintaining domestic expansion. The same holds for foreign economies. As noted earlier, the real question is whether or not further cuts in rates will restimulate the economy. This remains to be seen.

Thomas Dillman is the former President of Mutual of America Capital Management LLC.

1

PBS NewsHour, "As Europe braces for Brexit, the Netherlands sees benefits," October 6, 2019.

2

Chris Low, AM Economic Comments, October 7, 2019.

3

Chris Low, AM Economic Comments, October 7, 2019.

4

Strategas, Global Survey Insights, October 4, 2019.

5

Cornerstone Macro, "Economic, Policy, Strategy & Technicals," Michael Kantowitz, September 2, 2019.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.




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