What November means for 2019

Putnam Fixed Income Team, 12/11/18

What November means for 2019

  • The U.S. and global economies are decelerating
  • While recent U.S. labor data is strong enough for the Fed to hike rates in December, the Fed may pause in 2019
  • Despite a 90-day U.S.–China truce, the trade war may continue to destabilize equity markets

Entering November, the two greatest risks to the economy were a hawkish Fed and a further escalation of the trade war. We can now assess whether these risks changed.

Fed Chair Powell made remarks during November that were widely seen as dovish. However, these remarks appeared to be contradicted a few days later by other senior Fed officials. The story was similar with trade. On the margins of the G-20 meeting in Argentina, the United States and China agreed to a temporary cease fire in the trade war. However, President Trump, shortly after hailing the prospect of an imminent trade deal with China, proclaimed himself a “Tariff Man” and renewed the threat to impose tariffs on imported automobiles.

The Fed may be focused on the wrong data

The Fed is at risk of making a policy mistake by focusing too much on the labor market and worrying too much about the Phillips curve, or the tendency of low unemployment to drive up inflation. The policy mistake would be to tighten interest rates too aggressively. Rate hikes have already been having an impact on the real economy, with weakness beginning to be evident in the most interest-rate-sensitive sectors. Yet, prior to November, senior Fed officials appeared to be stressing that rates still had a distance to go before reaching neutral.

Fed Chair Powell seemed to take a different tack in a speech in New York in late November. He characterized rates as being “just below the broad range of estimates of the level that would be considered neutral for the economy,” and he emphasized that “there is no preset policy path.”

A pause in rate hikes would be an appropriate response to the outlook for a slowing economy with no signs of building inflationary pressure and with great uncertainty over prospects for global trade. The Fed will recognize this. But the risk is that they get it wrong.

The trade truce is a cease fire, not a peace treaty

As became obvious a few days after the dinner meeting between the presidents of the United States and China, we lack a clear understanding of what was actually agreed upon at the G-20. Perhaps it isn’t clear to anyone what was agreed on, and perhaps that’s why an agreement was possible.

A pause in rate hikes would be an appropriate response to the outlook for a slowing economy with no signs of building inflationary pressure and with great uncertainty over prospects for global trade.

It’s helpful to separate two aspects of what has been under discussion between the two countries: on one hand, the bilateral trade position, and on the other, the broader issues of IP protection, state-directed capital, and non-tariff barriers to trade.

To help reduce the bilateral trade imbalance, China has agreed to increase its imports of a range of U.S. goods, including agricultural and energy commodities. However, changes in bilateral trade positions don’t mean very much from an economic perspective.

China might be willing to reach a deal on intellectual property issues; President Xi’s reformers could see that as being in China’s interest. But there is no prospect of China being willing to cede ground on its state-owned enterprises and its domestic capital allocation system. It’s very hard to imagine that in a mere 90 days, the United States and China can agree upon a serious set of structural reform measures.

President Trump is unlikely to embrace the short-term economic and financial disruption that major changes to this relationship would entail.

What will President Trump do? What’s most likely is an agreement that falls well short of remaking the Sino-American economic relationship. President Trump is unlikely to embrace the short-term economic and financial disruption that major changes to this relationship would entail. The risks, however, remain to the downside, not least because the drama itself is costly. We could end up with economic and asset market effects that materially worsen the 2019 outlook.

The central outlook is for slower GDP growth with risks skewed to the downside

Based on the developments of November, trade and Fed policy remain the two biggest risks. We believe that the trade war has not ended, but a further escalation appears less likely than it did a month ago. Also, there is reason to believe that the Fed will be less hawkish. However, a more aggressive trade stance toward China and a Fed mistake cannot be ruled out.

The central scenario continues to be a slowing growth rate, but not a recession, in 2019.

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