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Investment outlook
The economy and markets
Section 3: The economy and markets
Key points to know
Economic cracks are emerging.
The U.S. and global economies continue to expand at a healthy pace. We anticipate growth will start to decelerate over the balance of the year, and that dynamic is starting to play out in the data. After several consecutive quarters of upside surprises, key indicators are starting to show softness. Job creation has turned uneven, with a sharp deceleration in April followed by a resurgence in May. Other labor market data – including job openings, the quits rate and surveys of business sentiment – have been showing signs of weakness.
Meanwhile, the outlook elsewhere remains tepid. In Europe, conditions have improved but overall economic growth remains weak, with manufacturing facing fresh headwinds. Property sector woes and weak consumer sentiment are negatives in China, though growth has stabilized across emerging markets.
Sticky inflation? Yes. Stagflation? No.
After the first quarter U.S. GDP print showed disappointingly weak headline growth and surprisingly sticky inflation, investors faced the prospect of an unwelcome mix of weak growth and high inflation. However, we think both halves of the stagflation concern are overblown. Though real GDP grew at only a 1.3% annualized rate in the first quarter, that number is somewhat misleading, as growth was dragged down by a -1.3% hit from inventories and net exports. We’re penciling in a slowdown to around 2% by year end, which still represents a decent level of growth.
On the inflation side, core services prices have proved sticky over recent months, as we expected. We anticipate some modest easing in key areas like housing over the balance of the year, but movement is likely to be slow and uneven. The progress has been better elsewhere in the world. Core inflation in Europe and Japan is down to annualized rates of 2.9% and 2.5%, respectively, while consumer prices have been overall flat in China.
Global monetary policy divergence is back.
These varying economic and inflation outlooks across countries and regions translate into divergences in monetary policy. The European Central Bank and Bank of Canada cut rates in June (following earlier cuts in Switzerland and Sweden), and we expect additional cuts in the coming months. The U.S. Federal Reserve is likely to hold off in the near term, while the Bank of Japan should keep moving in the opposite direction, hiking rates again by year end (Figure 2).
We have not seen this degree of global monetary policy divergence since 2016. Historically, varying policy actions have resulted in increased volatility across economies and markets. Ultimately, central banks tend to resynchronize, with neither the most-hawkish nor most-dovish forecasts being correct. In the current context, we think the Fed is unlikely to completely buck the global trend toward lower rates, but it is also likely to move slower than many expect. If the Fed cuts once or twice this year the overall level of U.S. interest rates will remain quite elevated versus history.
The Fed will likely cut rates this year, but the pace of rate cuts may be slower than many expect.
Investors anxiously focus on election season.
The recent election results in Mexico and India serve as good reminders that politics can drive financial market risks (both the AMLO landslide in Mexico and the BJP party failing to win a clear majority in India elevate some legislative risks). The focus on the November U.S. presidential and congressional elections has been intensifying, as voters and investors alike wonder how different outcomes could shape the direction of the economy and markets.
Overall, we expect market volatility will rise as we approach the U.S. elections, but regardless of the outcome, the removal of uncertainty should eventually calm markets and possibly inject a modicum of risk-on sentiment. U.S. tax policy is of particular importance, given the scheduled expiration of the 2017 Trump-era tax cuts. If the results skew more Republican, those cuts are likely to be extended or made permanent. In contrast, clean energy tax credits would likely be expanded with a more Democratic result. Additionally, the U.S. must tackle rising debt levels, although we doubt significant spending cuts will occur regardless of the outcome. Health care and energy policy, the regulatory environment and trade issues are also very likely to evolve after November.
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All market and economic data from Bloomberg, FactSet and Morningstar.
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