Recession fears fading
Bottom Line From an oversold 3.25% in November 2018, benchmark 10-year Treasury yields plunged to an overbought 1.45% in early September 2019, as investors were clearly pricing in an elevated risk of recession. But over the past week, recession fears have seemingly faded, and yields have spiked to 1.75%. To be sure, the yield curve (as defined by the upper band of the federal funds rate, currently at 2.25%, and the 10-year Treasury) is still moderately inverted. But with the Federal Reserve ready to cut interest rates by another quarter point at their policy-setting meeting next week on Sept. 18, the curve is starting to flatten.
Moreover, after next week, we believe that the Federal Reserve will still have another insurance cut or two up its sleeve for the Oct. 30 and Dec. 11 meetings. As a result, the S&P 500 has rallied by about 7% over the past month, erasing most of the waterfall decline that drenched investors during the first half of August.
While it’s been our out-of-consensus view that there’s no recession on the proverbial horizon—a call we made for 2018, 2019 and 2020–the market finally agrees with us. The question is why? An interesting economic dichotomy appeared last week, between sluggish manufacturing data (ISM manufacturing in August hit a contractionary 3-year low at 49.1) and robust consumer spending (ISM services in August hit a 3-month high at 56.4). Manufacturing accounts for only 11% of the economy, so the healthy consumer is clearly driving the bus.
The labor market hasn’t been this strong in half a century, consumer confidence is just off an 18-year high and retail sales have been rock solid for the past five months through July. In addition, inflation has firmed, with nice year-over-year increases in August for both core CPI (2.4%) and PPI (1.9%), and core PCE has stabilized at 1.6% in both June and July.
We believe manufacturing and corporate capital spending have been weak in recent months because of concerns about the ongoing trade and tariff war with China. But the skirmish appears to be thawing at the margin, with both Presidents Trump and Xi offering concessions ahead of possible high-level meetings in October and November, after China celebrates the 70th anniversary of the founding of the People’s Republic of China on Oct. 1.
Overseas worries still dominate the investment landscape, with a possible German recession, ongoing Iranian nuclear and energy issues, October deadlines regarding Brexit, Japan’s VAT tax increase and the transition of the head of the European Central Bank from Mario Draghi (after a successful eight-year term) to Christine Lagarde. While we continue to anticipate heightened volatility over the next few months, we reiterate our year-end target of 3,100 for the S&P 500.
Tweaking our GDP forecasts The equity and fixed-income investment professionals who comprise Federated’s macroeconomic policy committee met Thursday to discuss fading recession fears:
- We revised second-quarter GDP down a tick to 2%, compared with more robust first-quarter growth of 3.1%. The final revision of the former comes on Sept. 26.
- The Department of Commerce will flash third-quarter 2019 GDP on Oct. 30. While we expect solid Back-to-School retail sales, we still lack a China trade deal, which has negatively impacted manufacturing, capex spending and inventory accumulation. As a result, we reduced our growth estimate from 2.4% to 2.2% while the Blue Chip consensus increased its from 1.9% to 2% (within a range of 1.6% to 2.5%). The Atlanta Fed’s GDP Now estimate is 1.9%, up from 1.5% last week.
- We expect much better retail sales this Christmas compared with 2018, but we clearly don’t know if the stronger pace of Chinese exports we were expecting from an eventual trade deal will actually start to happen this quarter. So we trimmed our fourth quarter of 2019 growth estimate from 2.6% to 2.4%, while the Blue Chip consensus decreased from 1.9% to 1.8% (within a range of 1.2% to 2.3%).
- Commerce conducted its annual benchmark revisions going back five years at the end of July, and the cumulative effective negatively impacted the baseline for our full-year 2019 forecast, lowering it from 2.7% to 2.4%. The Blue Chip consensus reduced its estimate from 2.5% to 2.3% (within a tight range of 2.2% to 2.4%).
Our first-quarter of 2020 GDP estimate is 2.4%, compared with the Blue Chip estimate of 1.7% (within a range of 0.9% to 2.4%).
- Our second-quarter of 2020 estimate is 2.5%, compared with the Blue Chip’s estimate of 1.7% (within a range of 0.6% to 2.6%).
- Our third-quarter of 2020 estimate is 2.5%, compared with the Blue Chip’s estimate of 1.6% (within a range of 0.5% to 2.2%).
- Our fourth-quarter of 2020 estimate is 2.5%, compared with the Blue Chip’s estimate of 1.7% (within a range of 0.8% to 2.2%).
- We are still expecting a Chinese trade deal to come by the end of this year and that the U.S. will begin to ship increased export volume to China during 2020. So we kept our full-year 2020 growth estimate unchanged at 2.4%, while the Blue Chip consensus left its estimate unchanged at 1.8% (within a range of 1.2% to 2.2%).