As we embarked on this year, I expected 2019 to be the year of
slower growth but better policy. And that, I posited, would be better for
financial markets than 2018’s combination of strong growth and bad policy,
specifically Federal Reserve (Fed) interest rate hikes and trade tariffs.
The Fed changed its game plan in 2019, signaling a major
change in approach at its January meeting and delivering a rate cut in July.
The Fed’s pivot to a more dovish policy stance was self-evident, given the late
2018 tightening of financial conditions and the deterioration in inflation
expectations. Double-digit returns in the broad US market1 have thus
far validated the Fed’s approach.
Alas, the Fed’s backtrack alone has not been enough to quell
concerns that a cycle-ending policy mistake is just around the corner. Only
this time, unlike all other cycles, the focus is on the Trump administration’s
trade policy and less so on the Federal Open Market Committee.
To be clear, the type of market drawdowns that punctuated August, in and of themselves,
should be expected. They happen almost every year and typically arise amid
policy uncertainty. That much we know. Herein lies the rub — the longer the
uncertainty persists, the longer we expect volatility to persist, irrespective
of the potential long-term outcome. To tweak a famous phrase from the Clinton
era: “It’s the uncertainty, stupid.”
The problem with
Protectionism leads to inefficient economic outcomes but doesn’t
necessarily lead to recessions. Uncertainty, on the other hand, grinds business
investment to a halt. During past bouts of uncertainty, we’ve seen the flight
to quality commence with all the trappings — the dollar rallying, the yield
curve flattening, oil prices falling, high yield spreads widening, and equities
selling off. It was only when policymakers reminded themselves to do no harm did
we see the trade unwind and equities regain their elongated secular run.
To be clear, this is not intended to be a statement on the
long-term trade policy for the country. Nor am I saying that all issues need to
be resolved today. Trade conflict between major nations is as old as time. In
more recent history, the UK complained in the 1700s of the US stealing
intellectual property. Britain and Germany battled for trade supremacy from
1914-1918 — and again 20 years later. For those keeping score, markets did
fabulously well in the 20th century in spite of it all. Rather, my point is
that businesses need to know that the rules of the game will not be changing
from day to day.
James Carville — the political advisor who rallied Bill Clinton’s
presidential campaign around “the economy, stupid,” — had another famous
saying. To paraphrase, Carville said that if he could be reincarnated as anyone
(or anything), he would come back as the bond market so that he could bully
everyone. Indeed, as of this writing, the yield curve is now modestly inverted
and the bullying has begun.
Given the low rate/inflation environment and Fed policy
accommodations, I believe that the markets want to go higher. I maintain my
position that slowing growth and better policy wouldn’t be such a bad thing for
markets — but as we hurtle toward the end of the year, it remains to be seen
whether policymakers can trade in short-term uncertainty for a stable,
long-term trade framework that can boost business confidence.
1 The S&P 500 Index returned 20.24% for the year through July.
Source: FactSet Research Systems
Blog header image: Mads Schmidt Rasmussen / Unsplash.com
An inverted yield curve is one
in which shorter-term bonds have a higher yield than longer-term bonds of the
same credit quality. In a normal yield curve, longer-term bonds have a higher
The Federal Open Market
Committee (FOMC) is a 12-member committee of the Federal Reserve Board that
meets regularly to set monetary policy, including the interest rates that are
charged to banks.
The S&P 500® Index is an
unmanaged index considered representative of the US stock market.
The opinions referenced above
are those of the authors as of Aug. 29, 2019. These
comments should not be construed as recommendations, but as an illustration of
broader themes. Forward-looking statements are not guarantees of future
results. They involve risks, uncertainties and assumptions; there can be no
assurance that actual results will not differ materially from expectations.