Positive momentum in risk markets continued in January (S&P 500 +5.7%)
More hawkish rhetoric from ECB leaders weighed on long-end global government bond yields, and “quantitative tightening” remains a potential headwind for the global economy and markets
Overall U.S. economic data trend remains positive, and the underlying details of the Q4 GDP report were solid
The current expansion cycle is now in its 104th month and will soon only trail the 1990s as the longest post-WW2 expansion (120 months)
The positive tone in risk markets continued for much of January. Momentum from the recently passed Tax Cuts and Jobs Act (TCJA) was a tailwind for U.S. equities (S&P 500 +5.7%), and corporate credit spreads tightened another 6 basis points (bps) from what were already post-crisis lows. However, an increase in long-end Treasury yields as the month progressed began to weigh on equity valuations. In the recently-published 2018 Barron’s Roundtable, which surveys top investment experts across several asset classes, most participants are fairly bullish on global growth prospects in 2018. Much of this optimism is attributable to tax reform, and many expect wage and consumer price growth to rise throughout the year. One common concern is rising bond yields and the impact on stock prices (i.e., higher discount rates). As veteran tech investor Paul Wick describes it, “the discounting mechanism is going to take a chainsaw” to stocks with extravagant valuations as rates rise (a bigger impact for tech companies not expecting positive cashflow for many years).
The primary catalyst for higher long-end yields was hawkish rhetoric from European Central Bank (ECB) officials as it relates to the future of its current asset purchase program. This was something we discussed on several occasions last year as a major wildcard for financial markets in 2018. The Fed has been relatively transparent and predictable thus far in its policy normalization process, particularly its balance sheet reduction plan. The ECB has been less forthcoming, but with growth and inflation measures improving in the region, officials are naturally hinting at pulling back on the central bank’s extraordinary accommodation policies as well.
The ECB is still actively engaged in quantitative easing, but it has reduced the monthly pace of purchases. Recent statements by officials suggest they are leaning toward letting the current program expire in September. Since mid-December, Germany’s 10-year yield is up 40 bps (more than doubled), and France’s 10-year yield is up more than 30 bps. Over that same timeframe, the 10-year Treasury yield rose 35 bps, which was attributable to both selling pressure from global markets and higher market inflation expectations post-tax reform.
Data Trend
The overall data trend remained positive in January, and on the 26th, the first estimate of Q4 GDP was released. Headline growth was less than expected (2.6% vs. 3.0%), but the underlying details of the report were more encouraging. Personal consumption rose 3.8% (best since Q2 2016), and final sales to domestic purchasers surged 4.3%; the highest since Q3 2014 and a sign of stronger growth to come. Business investment was also stronger. The biggest detractors affecting the headline growth rate were stronger imports (increased trade deficit), which subtracted 113 bps, and less inventory building by businesses subtracted 67 bps. Average GDP growth for 2018 was 2.5%, which is the strongest four-quarter performance in 2.5 years.
With the current economic expansion in its 104th month, it is close to surpassing the 1960s (106 months) and 1990s (120 months) expansion as the longest post-World War II growth phases. Because of this, there have been heightened concerns that a recession is inevitable. However, as we have noted in the past, business cycles do not run on clocks. Historically speaking, you don’t see a recession without the Leading Economic Indicators (LEI) Index falling into negative territory. Current LEI is holding above 5.7% y/y, more than double the 2.4% average since records began in 1960. LEI is not a perfect forecasting tool, but current readings do highlight the fact that the data trend remains supportive of future growth.
Looking ahead, we continue to see the same potential headwinds related to monetary and fiscal policies. Regarding the former, quantitative easing programs in the U.S., Europe, and Japan had notable impacts on, at the very least, financial asset valuations. The Fed is now engaged in balance sheet reduction, which is effectively quantitative tightening, and the ECB appears poised to follow in the next year. This should amplify the impact of traditional rate hikes. How will it affect global growth and inflation? Regarding fiscal policy, the markets have responded very favorably to tax reform, particularly the potential benefits for both public and private businesses. However, at some point this jubilation may shift to deficit concerns later this year, particularly if the Trump administration progresses on an infrastructure spending bill. That said, there’s still no competition to the U.S. dollar as the world’s reserve currency, so the U.S. can theoretically run bigger budget deficits without suffering the consequence of significantly higher borrowing costs (at least in the near term).
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