Outlook and Market Review - Second Quarter 2019

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According to the Bureau of Economic Analysis the U. S. economy grew 2% in the second quarter following 3.1% growth in the first quarter of 2019. Overall, consumers fueled growth as investment slowed, the trade deficit increased and government spending posted a modest gain. The Fed’s higher interest rate policy last year had a lagged negative impact on GDP. Lower rate moves in 2019 will offer some stimulus later into 2019 and early 2020. The uncertainty of trade negotiations with China, Brexit turmoil, and political chaos are key drawbacks for business investment.

The OECD and World Bank recently provided lower estimates for global growth. Slower growth and trade tariffs will likely take a toll on U.S. exports while nudging import prices higher. Inflation remains within the Fed’s target boundary on a year-over-year basis, but more recent months have shown an uptick in inflation pressure. With a strong labor market and acceptable level of inflation on one hand, but slow global growth and total dependence on consumer spending on the other hand, the Fed is torn between a “wait and see” approach versus a series of lower rates. The last reduction of the Fed fund target to 1.75% was contentious with a narrow margin of support. Without a slump in job creation and weak consumer spending, the Fed will likely pause until the December meeting when another 25 basis point cut will be on the table.

Business investment continues to be dormant as trade and political uncertainty cloud expectations for U. S. growth. Business sentiment is fading and government fiscal policy is off the table, leaving only consumer spending as the source of continued growth. Consumers are in a position to expand spending based on high equity values, rising wages, full employment, and low inflation. The third quarter started off with a 0.4% increase in real consumer spending in July. Wages and salaries, which make up the bulk of personal income, are still rising at about a 4% rate, which will support disposable income growth and encourage spending. Higher incomes and lower interest rates will also lend support to home sales in the third quarter. The GM workers’ strike will be an important event to follow. Depending on the outcome, it may fuel more strikes as labor seeks a higher share of corporate profits. Overall, GDP growth in the third quarter is likely to be 2% to 2.25%.

For now, the yield curve is likely to remain flat or slightly inverted. Even with lower U.S. short term rates, the U. S. dollar should remain strong given even lower interest rates abroad. A strong dollar and expectations for lower rates going forward are key factors in keeping longer term bond prices high and rates low. If a trade deal with China materializes and interest rates remain low, equity values should remain strong. The only caveat to this scenario would be if impeachment and the surrounding issues tilt the likelihood of a China trade deal before the election. Longer term trouble for equity values will occur if the prospects improve for a Green New Deal, Medicare for All, Free College Tuition and high tax.

The Chinese economy is faltering and trade tariffs are clearly causing an unwanted drag. The key issue is whether a solid trade deal can be achieved this year or if the Chinese believe that a better deal can be achieved after the 2020 elections.