9 Sept 2019
Risks Remain as Manufacturing Sentiment and Activity Continue to Be Weak
The theme to our 2019 outlook was “be prepared” and we continue to see some clouds forming on the horizon. Aside from trade/tariff volleys, the latest concern has been the inversion of the 10-year/2-year Treasury yield curve. Similar to the 10-year/3-month curve that first inverted in March—the 10-year/2-year inversion has preceded every recession since the 1960s. However, there were two periods—in 1966 and 1998—when the yield curve inverted, but a recession remained a fair distance away.
Recessions are inevitable and occur at the end of every economic cycle, so the U.S. economy is sure to have one. The unknown factor is the amount of time until it arrives, as the lead time from inversion until recession is highly variable.
Various pundits have dismissed both yield curves’ inversions this time around, citing the unique circumstance around why the curve inverted this year. Being mindful of the daring use of the phrase “it’s different this time,” the reality is that every cycle is unique in nature. This time around, the phenomenon of $17 trillion of negative-yielding global debt, citing Wall Street Journal, is certainly novel—and has undoubtedly led to significant safe-haven/higher-yielding purchases of longer-term Treasury securities. As such, unlike most past episodes, the curve inverted this time because long yields fell below shorter-term yields vs. the Fed raising short-term rates above long-term yields. That said, an inverted yield curve, when persistent, and regardless of why/how it inverted, does crimp or eliminate the spread banks can earn by borrowing short and lending long—typically constraining credit availability, a common precursor to recessions.
Trade tensions continue to mount
The trade picture has shown few signs of improvement, as global manufacturing continues to weaken and myriad manufacturers continue to express uncertainty and are holding off on capital spending due to the trade dispute between China and the United States.
Manufacturing around the world is reflecting trade pains
Due to the latest tariff escalations; and limited incentive for either side to compromise at this stage, we see little prospect of a resolution in the near future. Barring some minor positive developments, the general rhetoric over the past couple of months has shown no evidence of a conciliatory tone. The tit for tat continues, and the longer the dispute and escalations continue, the more damage it is likely to do to corporate animal spirits and capital spending intentions. The prospective risk is that manufacturing’s weakness starts to bleed into the consumer/services side of the economy. This may already be underway, with the latest services purchasing managers index (PMI) from Markit falling to 50.9. The slide coincided with a weaker manufacturing reading, which did dip to slightly below the 50 line. This weakness into services could be exacerbated by the fact that the next two rounds of tariffs on Chinese imports are a direct hit to consumer goods.
The sunny sky
For now, the U.S. consumer is chugging along. Retail sales in July surprised to the upside with a robust reading of 0.7% month-over-month while, excluding the more volatile autos and gas components, sales increased 0.9% month/month and 4.2% year/year. Consumer confidence remains solid due to wages trending higher and jobless claims sitting at historically-low levels.
Mid-cycle adjustment, or something more?
For now, the Fed appears to be more focused on the consumer’s strength in holding up the economy. The July Federal Open Market Committee Meeting (FOMC) minutes reiterated what Fed Chairman Jerome Powell noted immediately following the FOMC meeting last month—that the July rate cut was a “mid-cycle adjustment” rather than a “pre-set course” for an easing cycle. Yet, despite that, investors are still pricing in at least two more cuts this year. The divergence between these expectations and the Fed’s signaling will have to be resolved at some point, and market volatility could increase along with convergence.
Good news on trade
Though the back-and-forth between the United States and China has commanded nearly all the attention, President Trump and Japanese Prime Minister Abe worked to find common ground while at the Group of 7 (G-7) summit in France. In fact, President Trump stated that, “We’ve agreed to every point.” Japan is the third largest economy in the world, behind the United States and China; and agreed last week to a trade deal that would allow more agricultural exports from the United States, and avoid new tariffs on Japanese cars exported to the United States.
Lost in the escalating trade tensions with China is the fact that the United States now has trade deals signed or pending with Japan, South Korea, Canada and Mexico—making up four of the United States’ top seven trading partners—accounting for a combined 60% of U.S. trade.
While manufacturing continues to weaken and the U.S.-China trade dispute shows no sign of a resolution, the U.S. consumer continues to power the economy thanks to positive wage growth and a tight labor market. However, it’s prudent to be prepared for more bouts of volatility, and investors should make sure they are keeping a diversified portfolio with equity exposure equal to their risk tolerance. Within U.S. stocks, we continue to favor large cap stocks over small caps; while recommending a fairly defensive sector positioning, with emphasis on health care, utilities, and staples during market rebounds. We don’t recommend trying to trade around short-term moves, but rather focusing on the long-term, remaining disciplined, and using bouts of volatility as opportunities to rebalance.
Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.
Markit Services Purchasing Managers Index (PMI) released by Markit Economics captures business conditions in the services sector.
The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc, and the source of comments provided here.
About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research