Outlook and Market Review - Fourth Quarter 2019

The U.S. economy grew at a 2.1% pace in the fourth quarter of 2019, based on the revised estimate by the Bureau of Economic Analysis. On a year-over-year basis the economy grew 2.3%. Inflation remains well below the Fed’s 2% target for the core personal consumption expenditure index (PCE). The core PCE gained only 1.6% on a year-over-year basis. The headline unemployment rate ticked up to 3.6% in January from 3.5% in both December and November of 2019. Payroll expansion remains strong with 225,000 new jobs in January. Manufacturing continues to muddle along. The Institute of Supply Managment (ISM) index fell to 50.1 in February of 2020 from January’s 50.9 level. The benchmark for expansion is 50, suggesting that the manufacturing sector is lagging all other sectors. A decline in labor productivity in the fourth quarter of 2019 combined with a 4.6% increase in labor compensation resulted in a 5.9% increase in unit labor costs. When businesses are unable to raise prices, higher unit labor costs squeeze profit margins.

The economy produced good performance going into 2020 but the COVID-19 outbreak represents a “black swan” event capable of derailing U.S. and global growth. The epicenter of the virus is China but the nature of the virus makes global contagion a major concern for all countries. The U.S. has already suffered from supply chain disruptions, slumps in consumer demand for travel, and suspension of high social contact events. Additional spreading of the virus could well lead to shutdowns of schools, businesses, and public events. Projections of the impact on the U.S. economy are largely guesses about the severity and duration of the virus contagion. The policy response by the Fed was a surprising cut in the Fed Fund rate of a full 50 basis points. While most analysts expected the Fed to cut rates in response to the virus, the magnitude and timing were surprising.

The most dramatic economic consequence of the early stages of the virus outbreak has been a major decline in the stock market and bond yields. A flight to safety and large scale asset rebalancing pushed the markets well below a 10% “correction” and now threatens to be a full “bear market” condition. The Fed’s interest rate cut was designed to modify fears in the markets but many interpreted the signal as an indication that the Fed sees consequences of the virus to be worse than anyone thought. Markets are likely to continue a high level of volatility as new information about the virus develops slowly. The ultimate loss of wealth from the equity market collapse and potential loss of jobs and income from a prolonged virus attack will likely result in very low GDP growth rates in the first half of 2020. Beyond that, everything depends on whether the virus is seasonal and if it mutates to other more severe forms.