Current thoughts on the economy and the markets

July 9, 2019


The following is an edited excerpt from our recent Virtual Forum webcast. Vanguard Senior Economist Andrew Patterson from Pennsylvania and Senior Economist Alexis Gray in our London office discussed the current state of the markets and global economy. They also shared Vanguard's outlook for the rest of 2019 and beyond in a session moderated by Vanguard's Lara de la Iglesia.

Is it the end of the road for the economic expansion?

Lara de la Iglesia: As we approach midyear, it's helpful to reflect on the strong start we've had to 2019 and to understand the growing concerns that economic expansion may be ending and [that] a recession could be on the horizon.

Andrew, tell us, how has our economic outlook played out for the first half of the year since it was issued last fall?

Andrew Patterson: Well, in many ways, it's played out very much as we anticipated, but in other ways, not so much. In terms of fundamentals, at least here in the United States, on the growth side, inflation, what have you, has played out very much as we expected. Growth is still looking like it's going to trend somewhere around 2% this year, which is a little bit above longer-term expectations for growth. The difference there being that the run rate by the end of the year is likely to be somewhat slower.

So a little bit stronger growth unexpectedly in the first half of the year; it's likely somewhat slower growth, somewhere around 1.7% quarter on quarter, heading into the end of the year.

That was one of the reasons why we made a change to our Fed call. … Given some of the recent uptick and uncertainty around trade, around fundamental growth numbers toward the end of the year, we've since changed that call to two cuts. So the Fed is likely to reduce the policy rate by around 50 basis points over the next coming, couple of, meetings.

One of the big drivers for us changing our call, really, comes from the bond market, comes from the shape of the yield curve. So, current state, there is an inversion in the yield curve. What that means is that the yield on the 10-year Treasury, so the longer end, is actually lower than the short end. So you're not getting that compensation that you would have for taking on what's termed duration risk, so holding a longer-duration product.

That tends to be a pretty strong signal of recession in the past, not today, tomorrow, but 12 to 18 months out in the future. It's been right the majority of the time; there have been times where there's been false positives, but that really is one of the reasons why we changed our view. But if you're looking just at the fundamentals, there really wasn't much of a call for a change in Fed expectations, right?

Trying to get at the heart of what's driving that change in the shift of the yield curve, that's driving it to be inverted, again, it's difficult to predict with precision. We think a lot of it has to do with the flight to safety, uncertainty, right, some of those trade tensions. So the Fed trying to counteract that, likely with rate cuts in coming quarters.

Outside of that, I'll let Alexis speak to Europe, but in terms of Asia, our expectations heading into the year were for GDP growth in China somewhere around 6.2% to 6.5%. We've since narrowed that band to be somewhere closer to the bottom of that. So, likely somewhat slower growth, or at least toward the bottom of our range of expectations that we had heading into the year.

Alexis Gray: Yes. I would echo Andrew's sentiments there where fundamentals have broadly played out as we expected. Growth, perhaps just a little bit softer in the euro zone this year, but the main surprise, I think, has been on the risks, particularly around the trade war which has ignited between the U.S. and China. That trade war does not seem to be fading away, and so the risks to our outlook really skewed to the downside at the moment. And that means that the likelihood of the ECB [European Central Bank] raising interest rates even next year has now diminished. … At this point, I think, if anything, if the ECB is going to move monetary policy, it will be to loosen it and try and support economic growth and reduce those downside risks.

Recession ahead?

Lara de la Iglesia: Andrew, I have a question here from Michael in Santa Ana, California. And Michael asks, "What's Vanguard's forecast on a recession? And what indicators, importantly, do you use to help inform your forecast?"

Andrew Patterson: Sure. So I mentioned earlier the impact that an inverted yield curve can have on recession probabilities, right, has been a very good predictor in the past. If you're looking only at yield curve inversion, as deep as it is, as long as it's persisted at this point, you're looking at north of 50% odds over the next year. That, we don't believe you can take that just in isolation. There are other factors that you have to consider as well. Some of the others that are talking to the idea of a recession, or higher probability of a recession that is, the housing market, right, slowdown, moving sideways a bit in some of the indicators, but that's been a bit of a slowdown over the last several quarters.

On the positive side, though, as I mentioned earlier at the outset, economic fundamentals aren't that bad right now, right? Whether it's growth, consumption remains relatively strong, the first quarter aside. That is a risk that we're keeping an eye on though. We highlighted that in our 2019 outlook paper. So if the consumer sector were to continue to slow down, then we may have to reassess our probability of recession, or at least deep slowdown. Factors like consumer credit, right, still relatively strong demand, and supply of credit. So if you look, really, just at financial markets, the fixed income market in particular, they're pointing to a base case of a recession, whereas, if you start incorporating other broader fundamentals—growth, inflation, consumption, what have you—they're pointing to somewhat lesser odds; let's call it 20%–25%. You combine those, and that's where we're sitting right now at around 40% odds of a recession over the next 12 months.

Lara de la Iglesia: Andrew, I'm going to start with a question for you. It's from a gentleman named Edward in Huntington Station, New York. And Edward asks, "While the markets seem to want a Fed rate cut, would the next-day thinking be that the Fed sees something bad coming

Andrew Patterson: So I think the first part of that question, the idea that the market sees a rate cut coming, I think that really lends itself to the idea that the market's pricing it in already. So if there's some sort of fear that, by the Fed cutting rates, they're getting out in front of the market and inducing fear of a recession, I think, very much the opposite. They're actually reacting to fears that are already priced in, right? Fears, again, around trade tensions, flight to quality, that type of stuff. So I wouldn't say that if the Fed were to cut rates, it would be much of a surprise to the market. It is going to depend a lot on the communication around those cuts, if there were to be cuts.

What does the inverted yield curve mean?

Lara de la Iglesia: I have a question here about the yield curve. … Gregory asks, "Does the signaling of an inverted yield curve lessen when the impact of quantitative easing is considered? So, for example, if long-term yields were not artificially as low as they are, would we maybe not be inverted?" Maybe I'll start with you, Andrew, on that one.

Andrew Patterson: So that's one of the discussion points in economic and financial market circles going on right now, is this time different? Is it different now that the yield curve is inverted because of policies like quantitative easing that have kept longer-term rates, or at least their intention was to keep longer-term rates, somewhat lower? I have a hard time buying in to that fully. I think maybe there's a case to be made that the slope of the yield curve, so the term premium, if you will, the additional yield that you pick up for investing in longer-duration securities, maybe that's a bit lower. But for the yield curve to actually invert, for you to get compensated more for holding short-term debt than longer-term debt, the signaling power of that tends to remain, in our view—we actually had a Global Macro Matters piece about that released about a year ago. So we think that does still have some signaling power. Whether it's as strong as it was in the past, that certainly is up for debate.

And, again, as I mentioned earlier, we're not talking about a signal of a recession today, tomorrow, next month. We're talking about 12 to 18 months out. So that's what the Fed is trying to do, is get out in front of this, and be more proactive, again, if they were to cut rates in coming meetings.

The impact of tariffs

Lara de la Iglesia: Could we dive a little bit deeper into the potential short- and long-term impacts of tariffs. Andrew, I'll start with you there.

Andrew Patterson: So in terms of the short-term impacts, actually, you know, sometimes policies like tariffs or a trade war, there's going to be winners and losers in any sort of conflict like this. You could actually see some industries benefit, you could actually see some countries benefit in the short term, right?

Longer term, it's really more about the size of the economic pie. And globalization has done a great job of increasing the size of that pie in aggregate.

Now, when you start talking about the distribution of that pie and which countries are receiving which benefits, or which industries, or even which individuals are receiving those benefits, that's what I don't think has been communicated as well as it could have been over the last years, decades, if you will. There are winners and losers in any sort of, whether it's a trade war or a de-escalation of trade tensions, and I don't know that that's been acknowledged to the extent that it should have been.

So you have these factions, these regions of—we'll use the U.S. as an example—regions of the country, industries, like the automobile industry, factory workers that have borne the brunt of some of these policies. And it wasn't really explained to them that they should expect this type of outcome and that there would be some support in some way for them.

So I think going forward, that needs to be acknowledged by policymakers, and that needs to be considered when you're setting, if it's tariffs, fiscal policy, addressing issues like the social safety net. Those types of things need to be considered more than they were, and a public dialogue, I think, would go a long way toward calming some of those populist sentiments.

Lara de la Iglesia: Okay, okay. Alexis, any concerns there for the impact of tariffs at all in the economy, or certain sectors of it?

Alexis Gray: Yes. I mean, although the main trade war has been between the United States and China, there are spillovers from that trade war. Countries across Asia and Europe trade heavily with China. And so, if China is negatively affected, then that spills out across the region. And even, I would say, over the past 12 months, we've seen a slowdown in Europe, which, in part, has been triggered by this trade war. So, you know, it's not isolated to the two parties involved but really affects the entire global outlook when a trade war's taking place between the world's two major superpowers.

Financial market headwinds

Lara de la Iglesia: I want to move us on to a discussion about the market outlook. And, Alexis, I'm going to start with you. I have a question here from a woman named Jennifer in Seattle, Washington. And Jennifer asks, "What headwinds do we need to be aware of, and which are the most worrisome or impactful, for financial markets?

Alexis Gray: I think, fundamentally, the market outlook is driven by the economic cycle. So anything that would trigger [a] sharp slowdown in growth or a recession is something that we worry about in the markets. And even recently, as I mentioned, you know, we've had these trade tensions flare up between the U.S. and China in particular, and that, I think, worries people that perhaps it will lead to a recession and potential downturn in the market.

So the trade war, I would say, is just about the biggest global risk at the moment. We believe that there is a reasonable chance that a deal will be struck, at least some sort of handshake deal in the next several months. But, equally, you know, so far that kind of tension has been a little unpredictable, and it's possible that this is part of an ongoing kind of strategic battle between the two countries and we could even see, as [President Donald] Trump has warned, an increase in the amount of tariffs imposed on China, which could be bad for growth.

So that's, I'd say, our number one risk. I mean, there are a few others that we worry about. Obviously, if Brexit were not to play out very well, and there was no deal struck, and the U.K. left the European Union abruptly, that would not be good and potentially bad for markets.

Those are probably the two biggest risks, I would say.

Andrew Patterson: Yes, and I would agree, and just kind of putting a little bit of a finer point on it, in terms of uncertainty, right, we've all heard the old cliche, financial markets hate uncertainty, right? But, really, at the heart of that, it's what impact uncertainty has in economic fundamentals. Alexis mentioned that near term, longer term, it's really the impact on GDP growth and expectations for earnings that tend to have implications for whether it's dragging down or supporting equity prices. You start talking about a prolonged trade war, you start talking about the uncertainty associated with that, we did some research headed into the year that showed just what type of drag uncertainty would have on fundamentals, on GDP growth.

So, if you have elevated levels of policy uncertainty, even more so than today, maybe akin to what we saw heading into the first quarter this year, if that were to persist for two quarters, you're talking about a 50–60 basis point drag on GDP growth over the year. That's pretty substantial.

Lara de la Iglesia: Andrew, I'm going to stick with you for a moment. … So this is a question from Matt. He says, "With the 40% likelihood of recession, are you surprised that stocks, at least in the U.S., are near all-time highs?"

Andrew Patterson: Not necessarily. I'll keep pointing back to fundamentals; growth is reasonably strong. It's expected to remain around a reasonable trend of 2%; maybe a little bit below. That's not high by historic standards. Then you consider other things, like interest rates. Interest rates, in our view, and in the view of many in the marketplace, as reflected in the inverted yield curve, are likely to be low and remain low for some time.

What that means, at least in part, based on financial theory, is that the discount rate for those future cash flows, which are likely to be reasonable if growth is reasonable, the discount rate is lower, so equity prices, somewhat higher equity prices, can be supported. This is something that's reflected in models that we use, such as our fair-value CAPE model. Rather than simply using the historic or the trailing ten years of earnings divided by today's price, we account for factors, economic factors, that is, yields, right, expectations that are baked into those yields, inflation, inflation expectations, and show that, given the current low level of yields, given the current low level of inflation, inflation expectations, you can justify somewhat higher equity valuations.

Now, we're not saying they're not stretched today—particularly here in the United States, we believe that valuations are a bit outside of the range of what you would expect, given those fair-value assessments—but it's not, certainly, nothing that's sounding alarm bells, like the mid to late 1990s. And even then, again, we talk about the futility to trying to market-time. Even then, those returns continued for another five, ten years. So some investors who may have been heeding those signals and made significant changes to their portfolio allocation may not have been able to take advantage of the continued run-up despite less than advantageous fundamentals.

Is the bull market over?

Lara de la Iglesia: Do we believe, do you believe, that we're in the middle stages or the late stages of a bull market?

Andrew Patterson: So I would say that we're middle, late middle, or early late, right?

Yes. We're moving toward the later stages of the cycle based on a number of different factors. The only ones that have really changed since we initially did the analysis toward the end of last year, really, have been policy, and I mentioned before the risk of policy being too tight has abated somewhat. So that would signal for being closer to maybe toward the middle, right, if expectations aren't for a continued tightening. Asset prices retrenched a bit, but then it bounced back. So those are really somewhat similar to what we had heading into the year.

So, again, much like our expectations for fundamentals, not a whole lot has changed in terms of timing of the cycle. We have increased our probability of recession, right, based primarily on the yield curve, as we've mentioned. So, it's, for lack of a better term, it's, really, we're taking a wait-and-see approach. But, in terms of the scene, it's not just one signal or the other. It's not just looking at the yield curve. It's assessing all of those signals. It's assessing the yield curve, financial markets, housing market, economic fundamentals, when we're coming to the conclusion such as where we are in terms of business cycle.

Lara de la Iglesia: Okay, thank you. Alexis, do you have any additional thoughts to add on that question?

Alexis Gray: Yes. I think there is a lot of concern that we are coming into the later stages of both the economic and the market cycle, but you can easily make a case that the cycle continues for longer if the trade tensions dissipate. …

So this is the difficulty with investing. You know, it's very difficult in advance to know exactly where you are in the cycle. You can tend to look back and say, "Well, that's exactly where we were at that moment." But, in advance, it's hard to know. And that's why we often talk about investing in a kind of diversified fashion, and not making drastic shifts in your portfolio based on headlines.


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