The Economy and the Markets | Second quarter 2019

Key takeaways

• This expansion is in the latter innings, and late cycle concerns are emerging

• We expect the Fed to begin to ease in the second half of 2019, increasing the odds that the market extends its run

• Markets are pricing in a near perfect policy performance, tempering our enthusiasm 

Strong labor markets and a near record expansion are facing off against persistently weak inflation, decelerating growth and a possible earnings recession. Despite the economy’s stronger than expected 3.1% growth in the first quarter, macro-economic data have been mostly disappointing. Late cycle concerns have emerged as estimates for GDP growth in the second quarter of 2019 have come down from 2.4% at year-end to 1.7% today as cost pressures, trade tensions and global uncertainty take their toll.  These factors are pressuring corporate earnings, making a year-over-year decline likely for the second quarter in a row. On a brighter note, the labor picture remains exceptionally strong with unemployment of only 3.6% at nearly a 50-year low.  

While The Federal Reserve’s (Fed) base case calls for growth trending to a slower but more sustainable level, rate cuts are likely if the economy softens more than expected.  Interest rates – here and abroad – are signaling that investors are worried about a slowdown. Investors are betting heavily that the Fed is entering an easing cycle, pricing in four or more cuts over the next year. Worried investors are accepting a lower yield on 10 year treasuries than 90 day bills. A curve inversion is a “no confidence” vote in the Fed’s ability to stem a slowdown. It’s unusual to see such strong market conviction about the need for easier policy while the Fed continues to temper expectations, guiding to only modest easing this year. 

In 2019, all asset classes have performed well despite slowing growth and fears of a downturn.  Ironically, the catalyst for the second quarter rally was increasing conviction that the Fed will cut rates in the near term, prolonging the expansion.  The S&P 500 index® is now up almost 17% for the year.  Long treasuries have produced an equity like return, up almost 11% year-to-date (YTD) and 6% in second quarter alone. Corporate bonds produced YTD total returns of over 9%, with high-grade and high-yield credit returning 4.48% and 2.50% in the quarter, respectively. While Treasury bonds are pricing in an alarming slowdown, recent outperformance by cyclical stocks indicates that investors expect the Fed to act, extending the expansion.

While it’s almost certain that second quarter growth will mark a record for the longest U.S. economic expansion on record, market participants are clamoring for the Fed to cut rates to extend the run. We expect growth to slow but remain positive and close to potential in the second half of the year. While we don’t see an immediate catalyst for a recession and still believe it’s some time off, the economy’s margin of error is slim. Event risk is elevated, heightening potential downside. As the Fed weighs the pros and cons of a cut, policy uncertainty is growing. The market seems increasingly dependent on the Fed navigating this softer patch perfectly. With market expectations so far ahead of the Fed’s rate guidance, a rate cut is likely to be a necessary condition for continued performance rather than a pleasant surprise. However, if the Fed commits to a path of “insurance cuts” geared to head off slower growth and promote inflation, the economy could extend its run. We expect the Fed to begin to ease in the second half of 2019, a good backdrop for risk assets.  However, with some risk of a policy mistake and higher volatility, our enthusiasm for the rally is tempered in the current environment.