- US economy is strong, but the cycle is becoming more mature as the Fed tightens.
- China acknowledged slowing growth with a clear shift toward policy easing; global activity has likely peaked.
- Ample corporate liquidity is a huge positive but will ultimately not offset tightening central bank liquidity.
- Trade tensions will remain a headwind, exacerbating late-cycle trends.
Solid economic growth and strong corporate results, particularly in the US, boosted global equities. Tax cuts continued to support corporate profits, but ongoing Federal Reserve interest rate hikes and US-China trade tension have been exacerbating late-cycle pressures.
The US topped regional equity-market results for the second quarter in a row. More economically sensitive bond categories such as high-yield corporates fared well, though higher interest rates held back other categories. A mixed global environment proved less favorable for commodities and non-US equities. With the Fed tightening monetary policy, global dollar liquidity has begun to recede. Emerging-market (EM) currencies and other assets have faced headwinds in 2018, particularly those in the most vulnerable countries that have large current-account deficits and foreign financing needs.
Ten-year Treasury yields rose to their highest levels since 2011. Inflation expectations have not changed much, but real yields are at the upper end of their range since mid-2011, signifying a modest but sustained rise in inflation-adjusted borrowing costs.
Economy/macro backdrop: Global expansion is growing more mature, less synchronized
The global expansion remains solid, but many major economies have progressed toward more advanced stages of the business cycle. Global manufacturing activity continues to expand, but at a meaningfully slower pace. Manufacturing trends offer evidence of slowing global momentum and, along with elevated trade risks, remain a headwind for export-oriented economies.
China's industrial sector continues to signal significant weakness, and during Q3 China acknowledged the slowdown by fully shifting toward an easing stance. Policymakers there face a delicate balance of trying to ease conditions while not adding to elevated debt levels, a task made more difficult by an external sector no longer in surplus and facing rising US trade barriers. Emerging markets faced headwinds from China’s industrial slowdown plus looming trade uncertainties and global monetary tightening. Europe has experienced the greatest slowdown among developed regions.
Meanwhile, US recession risk remains extremely low. The US economy has kept to a very gradual progression through its business cycle, with mid-cycle dynamics remaining solid in the credit and inventory cycles, but with late-cycle trends growing more evident after years of tightening labor markets and gradually firming wage growth.
The corporate sector received a significant profit boost from tax reform in 2018, which has more than offset margin pressures caused by rising wages. Lower tax rates and higher cash flows reduce the need for corporations to raise capital, lowering the supply of US corporate securities. Decreased bond issuance has provided technical support to credit markets, whereas a record amount of stock buybacks (up nearly 30% over the past 12 months) has supported equity prices. This tailwind from corporate liquidity may fade as effects from tax reform dwindle over the coming year.
With the unemployment rate below 4%, tightening labor markets continue to help boost consumer spending. At the same time, tighter labor markets have put upward pressure on prices, with various measures of wages and consumer inflation showing signs of modest acceleration. In September, the Fed raised rates for the eighth time this cycle, further flattening the yield curve. Over the past 6 tightening cycles, the Fed has responded to falling unemployment and rising wages by continuing to raise rates, even after the curve inverted. This suggests to us that if wages are rising and labor markets remain tight, the Fed is likely to continue raising rates even if the yield curve inverts.
Aggressive US trade policy remains a significant risk. Rising trade barriers are a particular problem for those countries that are most dependent on global trade, investment, and supply chains, including manufacturing-based, export-oriented nations such as South Korea and Germany. Because China and the US are the most central players in the highly integrated global trade network, escalating US-China commercial tensions represent a risk to global financial markets.
We believe the global expansion has become less synchronized, and the mature business cycle warrants smaller allocation tilts. As the Fed further reduces its balance sheet and the European Central Bank (ECB) ends quantitative easing at year-end, growth in major central-bank balance sheets is expected to turn negative by Q1 2019. After an unprecedented post-crisis period of global monetary easing, reduced liquidity may challenge demand for less liquid assets such as high-yield bonds and EM securities, potentially contributing to elevated asset-market volatility. The divergence between the US and the rest of the world presents opportunities for active asset allocation.
Asset markets: Growth stocks led US markets to another strong quarter
Growth stocks, particularly in the health care sector, spearheaded the risk-on quarter for US markets. EM equities declined slightly overall after a weak Q2, while Japan led non-US developed markets (DM) to modest gains. High-yield corporate bonds and leveraged loans posted the best returns among fixed income categories, boosted by solid economic and corporate fundamentals.
Historically, the mid-cycle has tended to favor riskier asset classes, while the late cycle has had the most mixed performance of any business-cycle phase. The late cycle often has featured more limited overall upside and less confidence in equity performance, though stocks typically have outperformed bonds. Inflation-resistant assets—e.g., commodities, energy stocks, and Treasury Inflation Protected Securities (TIPS)—have performed relatively well.
US earnings growth continued to improve on a trailing 12-month basis, helped by corporate tax cuts. Non-US developed and emerging market profit growth, however, has moderated from high levels. Forward estimates point to expectations for healthy but slower profit-growth rates for all 3 markets over the next year. Equity valuations remain above their long-term average in the US, below in non-US markets. Forward P/E estimates suggest investors expect DM and EM valuations to remain below long-term averages for the time being, while US valuations are projected to drop to near average levels.
In fixed income, interest rates rose for the third consecutive quarter, but bond yields remain below their historical averages. Credit spreads for US investment-grade and high-yield corporate bonds tightened significantly, while spreads for EM debt stabilized after 2 consecutive quarters of tightening and remain slightly below their historical averages.
Over the longer term, we believe the global economy has reached a secular trend of peak globalization. Changes to global rules may pose a number of market risks, including potentially higher inflation, lower productivity and profit margins, and higher political risk. Decades of disinflation have dragged down many investors' long-term inflation expectations, and we think peak globalization trends, plus changes in monetary and fiscal policies, could potentially cause inflation to accelerate faster than today’s subdued expectations.
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