What could lie ahead for economies and markets: strength and vulnerability
Based on a mix of supportive economic policies and positive market conditions, the second half of 2018 seems to be positioned for growth in the United States. But acceleration is never a sure thing despite what may appear to be an environment ripe for spending.
A US recession does not appear to be imminent, but an array of developments could lead to a premature cyclical slowdown recession and unexpectedly slow real economic growth.
Perhaps above all else, the key to the US economic outlook rests with the expected pace of capital spending and its effect on productivity, wages and the GDP.
No matter how trade relations play out over the years ahead, a complicated and extensive flow of goods, services, resources and intellectual property will continue.
US economic growth appears to be poised to accelerate in the second half of 2018, but the end of the economic cycle may be closer than anticipated by the consensus forecast. A pro-growth mix of economic policies has set conditions conducive to more rapid increases in consumer spending, business investment and labour compensation. Consumer spending is brisk and measures of business optimism seem to break records every month.
Capital spending plans
Investment plans have improved markedly since mid-2016
Sources: Morgan Stanley Research; Allianz Global Investors. Data as at 29 May 2018.
Past performance is no guarantee of future results.
Looking ahead to the second half of 2018, however, these outcomes cannot be assured despite their great promise. Households and businesses may well rethink their spending plans over the months ahead as they soberly evaluate the meaning of tax changes, government spending, economic policy adjustments and new risks to their well-being. If capital expenditures by businesses go to unproductive investment, productivity fails to accelerate and inflation-adjusted workers’ compensation does not increase, real economic growth could languish.
To be sure, Federal Reserve monetary policymakers will continue to base their interest-rate decisions on the flow of inflation, wage and labour market data. Yet how the Fed implements monetary policy over the next couple of years may be at least as important as the timing and magnitude of its policy decisions. Analysts to whom the Fed pays attention recommend that policy adjustments should focus increasingly on balance-sheet normalisation rather than policy-rate increases. A revised approach would hasten shrinkage of the Fed’s holdings of mortgage-backed securities with an eye towards their elimination within just a few years. Doing so would add precision and flexibility to policy implementation while also extricating the central bank from political pressures and a de facto fiscal policy role.
Nonetheless, if the Fed continues to make increases in policy interest rates the focal point of monetary policy implementation, fixed-income investors may have something to cheer. The reason is simple: over time, yield, not the change in yield, drives returns. Therefore, as rates rise, the total return to fixed-income securities tends to rise, not fall, with them.
Meanwhile, Congress and President Donald Trump's administration continue to implement a pro-business fiscal mix while also skirting around the letter and the intent of the legislated federal budget process. Fiscal policy likely will continue to reflect fractious political posturing devoid of critical details rather than well-reasoned, thoroughly debated bills. Henceforth, overall outlay and revenue decisions can be expected to take place in broad strokes of political expediency and with little regard for details. The appropriations process legislated into law in 1974 may well be defunct.
While the economic policy-making processes twist and turn, the interconnectedness of the US economy to others remains intricate and deep. Even as trade relations deteriorate, the forces of globalisation and technological revolution promise to defeat the forces of nationalism, populism and withdrawal from multilateral arrangements. Even if US-China and US-EU trade relations play out acrimoniously over the years ahead, for example, a complicated and extensive flow of goods, services, resources and intellectual property between the two nations will continue based, for the time being, on a co-dependency built up over the last three decades. In an interconnected world, developments anywhere can reverberate in anyone’s hometown.
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Three factors appear likely to shape the US economy through the rest of 2018: trade tensions, mid-term elections and the Fed’s road to normalisation. In a late-cycle environment marked by the potential for tail risks, investors should take a closer look at small caps, energy, high yield and alternatives.
Equities aren’t the only US asset class performing well in 2018: the dollar, high-yield bonds, Treasuries and small caps have also been positive
Trade tensions have increased global uncertainty, but we believe China isn’t inclined to escalate matters or retaliate much further
We see the potential for a strong year-end in the US; historically, the period after mid-term elections has been robust for the markets as uncertainty is lifted
Looking ahead to 2019, tail risks could emerge; we encourage investors to remain diversified and active, and to consider increasing exposure to uncorrelated assets