For the third consecutive summer selling in May and going away would have been folly. US equities melted up between July and September amid a strong economy and overcoming any concerns over trade. The S&P 500 Index hit new all-time highs as it gained 7.71% in the third quarter (Q3), well ahead of the Russell 2000 small-cap index, which gained 3.58% over the same period. The latter is still outperforming on a year-to-date basis with a 11.51% return, compared to 10.56% for the S&P 500.
However, the summer bounce in the US did not extend abroad. Developed economies across the world remained in a soft patch, in sharp contrast to the US economy. The MSCI EAFE Index (net) gained only 1.35% in Q3, leaving its year-to-date return in negative territory at -1.43%.
Emerging market woes continued, with Turkey taking the headlines but also US trade tariffs hitting China and rising oil prices putting a dent in India’s finances – the Indian rupee depreciated close to 6% against the US dollar in Q3, and has eroded 12% of its value over the first nine months of 2018. Weaker currencies saw the MSCI Emerging Markets index (net) fall -1.09% in the third quarter, sending its year-to-date return to -7.68%.
Global equities as a whole were buoyed by the US, with the MSCI All Country World Index posting a return of 4.28% in Q3 and a year-to-date return of 3.83%.
A larger appetite for US equities and a hawkish Federal Reserve meant there was less demand for fixed income. The yield on 2-year US Treasury bonds rose 29 basis points to 2.81, bringing it ever closer to the yield on 10-year Treasury bonds, which rose 20 basis points to 3.05. The Bloomberg Barclays Global Aggregate Index (unhedged US dollar) fell -0.92% in Q3, bringing its year-to-date return to -2.37%.
As we move into the final stretch of 2018, there are a few things we are keeping a close eye on, including trade and its impact on the developing world, the yield curve and monetary policy. We also game out a few post US midterm election scenarios.
1. Will US trade tensions with China escalate further even as tensions with Canada and Mexico recede?
The good news on the trade front is that frantic negotiations at the end of the quarter saw the US and Canada reach a deal, paving the way forward for the “US-Mexico-Canada Agreement” or USMCA. While this is ostensibly an agreement that will replace NAFTA, and labeled historic, the reality is that it is not very different from NAFTA. Tariff rates on imports from Canada and Mexico are still practically zero, and if anything, USMCA is even more pro-free trade. For example, protectionist measures that Canada placed to favor its dairy industry will be removed, giving US farmers greater access, while Canadian peanut, dairy and sugar farmers will have more access to the US market. Also, the agreement more or less protects Mexico and Canada from tariffs on autos and auto parts that are sent to the US – though there are stricter labor and rules of origin requirements, which could ultimately raise the cost of cars made in North America, or ship manufacturing out altogether.
At the end of the day, we have a free trade agreement that is not called a free trade agreement, and all three parties came out of the negotiations looking a winner. So the uncertainty over North American free trade has reduced, though not completely eliminated since legislatures in all three countries still have to ratify the deal (which will not happen in the US till after the November election).
The bad news is that trade tensions between the US and China have escalated, with tit-for-tat tariffs and restrictions. At this point negotiations appear to be at a standstill and the question is whether the two sides will engage in a protracted confrontation. In the short run, China appears to be the bigger loser. However, if the impasse continues, the blowback from a weaker Chinese economy could reach US shores as it did in 2015-2016. A depreciating Chinese currency, for example, could pressure its neighbors into making tough adjustments as well (since their major trading partner is China), at a time when they are already under stress.
Given how NAFTA and US-Korea trade negotiations ultimately resulted in only modest changes to existing agreements, despite strong rhetoric at the onset, there does seem to be a way out for the US and China. Especially if an agreement can be reached on intellectual property and technology transfer.
2. Will hawkish monetary policy invert the yield curve by the end of the year?
It seems redundant to keep discussing monetary policy and a flattening yield curve, but given its outsized importance late in the cycle – notably the recession forecasting power of an inverted yield curve – we believe it worthwhile to keep it on our list.
What is striking is that over the last few weeks of September Federal Reserve (Fed) officials have sounded increasingly hawkish. They clearly view the economic environment as having normalized, especially with a strengthening labor market. However, instead of pausing at a level where interest rates are neither stimulative nor restrictive, they appear inclined to err on the more restrictive side. At this point it looks like a pause may happen only if economic data starts to soften. Markets are already putting a 40% probability on one more rate hike this year and two more by June of 2019, which would bring the total number of rate hikes since December 2015 to 11.
The tonal shift from policymakers has led nominal and real yields higher across the yield curve. Yet yields on the shorter end have gone up more, leading to a flatter curve. In fact, the real yield curve briefly inverted (10-year minus 5-year yields) in September before ending the quarter flat. The bond market is clearly more pessimistic about future growth prospects than the Fed.
We do note that long-term yields surged during the first week of October, but it remains to be seen if the resulting curve steepening continues through the end of the year. Interestingly, rising yields have not been accompanied by a significant rise in inflation expectations, as measured by the difference between nominal yields and real yields (on TIPS).
A more hawkish Federal Reserve, combined with a substantial increase in the supply of US Treasuries (as the government makes up for recent tax cuts), means the US dollar is likely to continue its upward path. This will make things especially difficult for Asian Emerging Markets (EM), since they have significant US dollar denominated debt that will be harder to service. So any immediate recovery in EM will be dependent on what happens with US monetary and fiscal policy, not to mention trade policy.
3. Could US midterm election results lead to radically different fiscal policy in 2019?
As always, we refrain from forecasting, especially election results. Which is not to say we do not like to be prepared. Our preferred approach is to analyze potential scenarios that could result, focusing on the objectives of the players involved, and prepare for those. Post-midterms, the objective for Congressional Republicans/Democrats will be to keep control of the House and/or Senate, while for President Trump the overwhelming focus will be on re-election in 2020. Keeping these in mind, let’s walk through three scenarios, starting with the most likely one:
A) Democrats capture the House but Republicans hold the Senate: Which means divided government for the next two years. We are unlikely to see major legislation during this period. Any initiative that moves through a Democratic House is likely to hit a wall in the Republican Senate, and vice versa. At the same time, we do see them working together to keep the government funded. So current fiscal spending levels are likely to be maintained, or even increased if the two parties make a deal to boost both defense and non-discretionary spending.
B) Republicans hold the House and Senate: After being forecast to lose the House, Republicans including the President will see this as vindication of policies pursued over the previous two years. Which will result in them doubling down. They will probably try again to repeal the Affordable Care Act, while also pushing for more tax cuts around the margins. “Tax Reform 2.0” may include making the individual tax cuts permanent (which are now set to expire in 2025) and changes to the way capital gains are taxed. So even more fiscal stimulus, in the form of tax cuts.
C) Democrats capture the House and Senate: Again, divided government but quite different from scenario A above. While the immediate chatter in the aftermath of the election is likely to focus on impeachment, Congressional Democrats are unlikely to pursue this. Instead, they will probably look to consolidate their gains by passing populist legislation, and in this, they may actually have an ally in White House – one focused on cementing his own re-election prospects. A prominent example may include passing a large infrastructure package that provides an additional fiscal boost to the economy, and perhaps even a federal minimum wage increase. There is precedence for this from as recently as 2007, when Congressional Democrats together with President Bush passed an energy bill (which included higher fuel economy standards) and also raised the federal minimum wage.
Under each of the above scenarios, pushing against looser fiscal policy will be a more hawkish Federal Reserve and concerns over a rising deficit, which is rapidly closing in on $1 trillion. Yet the reality is that these very deficits are propelling higher growth in the US, and politicians in power will look to keep that streak going. Of course, as we discussed in a previous piece, this will be the first time since World War 2 that the US is experimenting with pro-cyclical fiscal policy this late in an expansion. In every other period, fiscal policy became increasingly tight as the expansion wore on.
We continue to closely monitor the macro picture for any fundamental shifts that can have a significant adverse impact on the global economy, and lead to a sustained bear market.
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