During Q2, the US-China trade tension escalated, providing an additional source of concern about the global growth slowdown. The world’s major central banks, acknowledging the weak global backdrop, shifted their tone more clearly toward an easing bias. These factors stoked volatility in global equity markets, while government bond yields dropped further. The mature global business cycle continues to warrant smaller cyclical allocation tilts.
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Safe-haven assets such as government bonds and gold were the best performers during Q2, while equities and riskier bond categories extended their year-to-date gains.
Both US equities and bonds benefited from the dovish shift in tone from global monetary policymakers that many investors hoped would lead to lower policy interest rates and greater liquidity growth. Commodities and emerging-market equities lagged as global growth indicators stayed soft.
Economy/macro backdrop: Mature US and global business cycles
Global growth momentum continued to slow, and most major economies have progressed toward more advanced stages of the business cycle.
The synchronized deceleration in global industrial production continued unabated, with the share of major countries with expanding manufacturing orders dropping below 50% for the first time since 2015. Global trade growth also moved into recessionary territory, weighed down by both the manufacturing slowdown and trade-policy friction, particularly between the US and China.
While policy stimulus continued to stabilize China’s economy, we believe a material economic reacceleration there is unlikely, and the currently mixed health of property markets remains key to China’s outlook.
The US is firmly in the late-cycle phase but with low near-term risk of recession. While a strong labor market and higher wages have buoyed US consumer confidence, the present large gap between current conditions and forward expectations has often occurred toward the end of prior economic cycles. Furthermore, the improvement in wage growth over the past 2 to 3 years has stalled in recent months despite a cyclically low unemployment rate and continued job gains.
The decline in the real cost of borrowing reflected end-of-Q2 market expectations that the Federal Reserve will cut interest rates at least 50 basis points during 2019.
Ten-year Treasury bond yields ended the quarter below 3-month Treasuries, inverting the yield curve. Curve inversions have preceded the past 7 recessions and may be interpreted as a market signal of weaker expectations relative to current conditions. However, the time between inversion and recession has varied significantly, and there have been 2 "head fakes" in which the expansion continued for more than 2 years.
After a gradual multiyear rise, inflation pressure has broadly softened over the past year across labor and commodities markets, with relatively contained employment costs helping boost near-term productivity measures. However, sustained increases in productivity rates typically follow periods of rising business investment by several years, and growth in capital spending has been relatively muted over the past decade.
We think global economic momentum has peaked and that trade-policy friction is negatively influencing corporate confidence. The Fed’s more dovish tone has provided near-term relief, but the global monetary backdrop is still tighter than 2 years ago. However, the change in tone from monetary policymakers globally offers a possibility that a more accommodative posture may help to lengthen the duration of the business cycle.
Asset markets: US assets led widespread rally
In Q2, US markets—led by financial-sector stocks and long-term bonds—spearheaded a broad-based appreciation in equity and fixed income assets around the world.
Performance differentials among US assets were unusually narrow, with most categories of both riskier and less risky assets posting modest to mid-single-digit gains. More-globally linked assets such as commodities and emerging-market equities lagged.
US earnings growth remained high but decelerated during Q2 after receiving a boost from corporate tax cuts in 2018. Meanwhile, profit growth in non-US developed and emerging markets remained in negative territory during the quarter. Forward estimates point to market expectations for a convergence of global profit growth in the mid-single-digit range over the next 12 months.
Using 5-year peak-inflation-adjusted earnings, P/E ratios for international developed- and emerging-market equities remain lower than those for the US, providing a relatively favorable long-term valuation backdrop for non-US stocks. After appreciating in 2018, the US dollar has been roughly flat during the first half of 2019, resulting in mixed but generally expensive valuations versus many of the world’s major currencies.
In fixed income, both lower interest rates and tighter credit spreads pushed yields lower for the second quarter in a row. Modest inflation, flagging growth expectations, and the Federal Reserve’s dovish shift supported bond prices. Bond yields in all categories are now in the bottom quartile of their long-term histories, with credit spreads also generally below their long-term averages.
Historically, the mid-cycle phase has consistently tended to favor riskier asset classes and result in broad-based gains across most asset categories. Meanwhile, the late cycle has had the most mixed performance of any business-cycle phase. The late cycle often has featured more limited overall upside for a diversified portfolio, although returns for most categories, on average, have been positive.
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