In July the U.S. economic expansion officially became the longest in U.S. history as it crossed its 10-year anniversary. As we pointed out in last quarter’s newsletter, the core economic vital signs for the U.S. suggest that the expansion has further to run with very few road bumps on the horizon to caution against a potential economic slowdown or recession lurking in the wings.
Let’s start with current estimates for 2019 GDP growth. After registering +3.1% in the first quarter and +2.0% in the second quarter of this year (up sharply from the initial +0.9% reading), many economists still expect overall GDP growth to annualize at +3.0% for 2019.
With an economy growing that strong, why are we experiencing an inverted yield curve which some believe can predict a recession ahead? As of the writing of this newsletter, the Fed Funds rate was 2.375% while the US 10 Year Treasury yields 2.12%. If short term rates are rising due to the removal of excess reserves (i.e. tight FED monetary policy), that would give credibility to an inverted curve as a recession predictor. However, Fed policy is neither restrictive from a measure of reserves (approximately $1.4 trillion in excess reserves) nor from a rate perspective, as the current Fed Funds rate is well below nominal GDP growth.
Therefore, the move down in longer dated U.S. Treasury rates is more likely a function of market-expected rate cuts by the Fed later this year.
If we compare the implied Price/Earnings (P/E) ratios for stocks versus bonds, the S&P 500 with an implied P/E of approximately 22 looks impressively cheap relative to the P/E for the 10 Year U.S. Treasury which is closer to 47 (1/.0212). When one overlays the cheapness of stocks implied by the relative P/E ratios against current economic factors such as 3% economic growth, benign inflation, job openings greater than total unemployment, retail sales +10.9% in the last quarter, and continued corporate earnings growth, the risk of the yield curve pointing to a looming recession seems unlikely. In fact, the case for further rate cuts seems weak.
The U.S. economy is the bright light globally as our policy makers have cut corporate tax rates, moved to a more economic friendly regulatory environment, and are maintaining an accommodative monetary policy. The slowdown in global growth becomes less of a factor. U.S. productivity and ingenuity coupled with access to capital within a more supportive fiscal and regulatory environment is taking the current economic expansion to unexperienced lengths.
What could mess this up? The most notable threat would be a bad outcome with U.S. trade negotiations and rising tariffs. In addition, the markets will react to a Fed decision not to lower rates. However, as noted above, current rate levels and liquidity should not slow the economy and the fiscal and regulatory environment should remain favorable until the next Federal election in 2020. In fact, further gains in the U.S. equity markets are quite likely in the second half of the year.
While the economic observations noted above might lead one to commit to a full “risk on” asset allocation reflected in 100% equities until economic factors shift, we believe diversified risk-based strategies still provide the most attractive approach for the proper stewardship and investment of liquid financial assets.