I am doing this in a guest post format, without blockquotes. You can download the entire article here as a Seven Steps and a Stumble PDF. I post major excerpts below, but not the entire article.
Suspended on the Brink
The MSCI All-Country World Equity Index has been stuck in a tight range since January of this year (Chart 1), but it now seems as if it is suspended on the brink of a sharp fall. With the Fed having already delivered seven rate hikes since January 2016, the central bank has become even more hawkish at a time of escalating trade tensions between the U.S. and its trading partners. The risk of policy overkill is escalating, and, as such we are downgrading global stocks and moving to overweight bonds versus equities.
I don’t expect a recession in the U.S. economy, but downward pressure on equities will likely be sustained unless or until the Fed backs away from its hawkish stance and/or the White House eases its harsh rhetoric. Both may happen in the third or fourth quarter when the U.S. economy softens, inflation calms down or the mid-term elections are over. Until then, bonds are a better bet than stocks.
U.S. Household Sector: Real Income vs Real Consumption
Chart 2 shows that Americans’ real disposable income growth is 2% and real private consumption is growing at a similar rate. With the savings rate having already fallen to 2.5%, which is close to a record low, it is almost impossible for consumers to double their real spending growth, unless they take on lots of leverage. Yet, consumer debt has been growing at a very subdued pace.
Despite this, Chairman Jerome Powell is more concerned about economic overheating and the strong labor market is emboldening policymakers to become more hawkish. I stick to the view that the U.S. economic growth will hit a “soft patch” in the months ahead.
The Treasury yield curve does not agree with Powell’s assessment and has flattened sharply since the Fed’s last decision.
Case for Soft Patch
Our Boom-Bust indicator for the U.S. economy is making a clear top, suggesting that the mini economic boom in the U.S. is cresting.
Although Trump’s tax cuts are stimulative, higher tariffs are anti-growth. These two policies are not only offsetting each other but are also creating enormous confusion for investors and businesses.
Dollar Inflation Expectations
Inflation will likely undershoot expectations in the third quarter, when the lagged impact of the strong dollar is felt (Chart 4).
Already, the U.S. monetary base is contracting (Chart 5) primarily due to higher rates and a shrinking Fed balance sheet. This usually heralds growth deceleration in the broad economy.
The bottom line is that Fed policy is always reactive, which by definition means that it is prone to policy mistakes. The Fed narrative seems to be that U.S. economic strength will be sustained, and inflation will creep higher. However, forward-looking indicators are telling a different story. This is not to mention that higher tariffs are higher taxes and therefore, anti-growth.
Profit Growth Decelerating
U.S. equity markets are facing several hurdles. First, forward earnings expectations are very optimistic, but underlying profit growth has already begun softening (Chart 6). What are the odds that U.S. corporations beat forward earnings projections, which currently stand at 22%?
It is possible, but not likely, especially if harsh rhetoric on trade turns into a tit-for-tat tariff war. Second, equity multiples will continue to be squeezed by rising interest-rate expectations — since the early 1970s P/E ratios for U.S. stocks have always come down whenever the Fed raised rates. This time should be no exception.
Finally, a rising interest rate cycle often leads to a period of rising price volatility (Chart 7). This is simply another way of saying that equities will face increasing vulnerability as rates move higher. Therefore, it is reasonable to expect Treasury bonds to outperform stocks as long as the Fed stays hawkish and Trump is willing to keep up brinkmanship with America’s trading partners.
Should the Fed indeed raise rates two more times this year, the Treasury bond market could rally sharply, taking yields down to 2.5% or even lower. The S&P 500 could fall hard. Two more rate hikes this year would constitute a policy overkill, in my view.
Trade Spat: Asymmetric Warfare
It looks as if President Trump is more interested in talking to his political base than having a cohesive strategy in dealing with trading partners. His approval rating has been rising and his base loves his approach on China and the EU. Therefore, Trump’s pressure tactics may not ease until the November elections are over.