The stock market has been hovering near record highs despite an assortment of economic and geopolitical risks. In the spirit of Halloween, we discuss some of the tricks and treats that might spook the markets between now and year-end. Trade remains the biggest worry, followed by bond markets, U.S. manufacturing activity, fear of a Fed policy misstep, and global geopolitical concerns.
The U.S.-China trade conflict remains a wild card for U.S. and global economies, and it headlines the list of concerns. The United States and China have reportedly reached a verbal “truce,” and by all indications a phase-one agreement may be signed at the Asia-Pacific Economic Cooperation (APEC) meeting November 16–17. China’s reported willingness to accept some level of ongoing U.S. tariffs and to discuss issues previously thought to be off the table, such as intellectual property protections, is encouraging.
At the same time, we acknowledge the potential for further escalation. Both parties want to portray strength, and they could choose to inflict more economic pain on each other to position for a better deal. China’s leadership also appears unwilling to make significant structural changes to its economy. China could wait out President Trump and take a chance on possibly negotiating with another administration after the 2020 U.S. presidential election. The controversy in Hong Kong is adding more uncertainty on top of an already complicated situation. Even if a phase-one agreement is signed in November, we may have a long wait for phase two, and we should expect the U.S.-China trade dispute will continue well into 2020.
The U.S. Treasury yield curve inverted (long-term yields falling below short-term yields) recently, thanks to a wave of intense global buying in U.S. debt. Many investors pointed to the inversion as a sign of imminent recession. While not dismissing this early signal, yields may have reflected the need for looser monetary policy rather than economic woes. Thankfully, two Federal Reserve (Fed) rate cuts and progress on trade negotiations have helped the yield curve climb out of inverted territory. The relative health of the credit markets, based on yield spreads for corporate bonds compared to U.S. Treasuries, is encouraging. However, if trade tensions flare up again or global economic growth slows further, this signal from the bond market could spark renewed recession fears.
After scaring markets with over-tightening and miscommunication in December 2018, the Fed has guided investors through its policy changes more effectively in 2019. The risk of a policy misstep still lingers, though, and there is a mismatch between the Fed’s and the markets’ expectations. Policymakers are expecting the fed funds rate to stay at (or just below) its current level through the end of 2020, while fed fund futures—essentially what the bond market thinks—are pricing in a 75% chance of at least two rate cuts over that same period. Investors positioning for a series of rate cuts may get
spooked if Fed policymakers stick to their projections. Also, should the Fed attempt to steer rate expectations higher by citing the resilience of the U.S. economy, we could experience additional market volatility. The Fed is expected to make one more rate cut of 25 basis points (.25%) this year, and we don’t think the Fed will take its policy rate below 1.5%, even in 2020. At that point policymakers might smoothly guide investors through an eventual pause in rate changes.
Even amid trade uncertainty, the U.S. economy is expected to grow, albeit slowly, in 2020 and beyond. However, the Institute for Supply Management (ISM) reports the U.S. manufacturing sector has recently begun to contract, sparking additional recession fears. Tariffs and trade uncertainty have been a part of manufacturing weakness. Historically, though, recessions have not occurred until an average of approximately four years after the manufacturing ISM has peaked, and the cycle-high ISM reading so far was a little more than a year ago in August 2018. Recessions typically have been accompanied by ISM readings in the low 40s, and the most recent reading was 47.8. Mid-expansion dips below 50 are common, with the most recent ones occurring in late 1995, 2012, and late 2015. The October manufacturing ISM report, due out November 1, is expected to rise to a less scary 49 based on Bloomberg consensus forecasts. Also, manufacturing comprises only about 12% of the U.S. economy based on gross domestic product. Consumer spending, which comprises nearly 70% of GDP, remains healthy.
Geopolitical risk may be the scariest for many investors, but unless something clearly goes wrong, it is also likely to have the least amount of market impact. Geopolitical hot spots include the United Kingdom’s “Brexit” and the related rise of populism in Europe, Hong Kong protests, Iran’s conflict with Saudi Arabia, Iran’s and North Korea’s nuclear ambitions, and Japan-South Korea tensions. Policy changes related to the 2020 U.S. presidential election may have more of an economic and market impact than geopolitical risks. Halloween is probably too early for markets to be leery of post-election policy changes. Yet, those potential policy changes will likely be priced in as we get closer to the presidential election.
The views expressedare provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by LPL Financial.
- All investing involves risk including loss of principal.
- All indices are unmanaged and cannot be invested into directly.