Economic Backdrop

Equity markets sold off around the globe at the start of August as the US-China trade war appeared to enter a newly heightened phase. With the promise of US tariffs extending to virtually all imports from China by September, China allowed the yuan (its currency) to depreciate against the US dollar to levels not seen since the 2008 financial crisis. This compounded concerns that the trade war would spill into a currency war. Volatility settled somewhat after spiking in early August, but remained elevated throughout the month.

UK share prices failed to recover from the early-month selloff as prospects of a reworked Brexit deal remained elusive. Prime Minister Boris Johnson made an effort to suspend Parliament until mid-October, leaving only two weeks for opponents of a no-deal departure to attempt to stop the UK from crashing out of the EU upon the planned departure date at the end of October. Sterling tumbled to multi-year lows versus the US dollar at the beginning of September after Prime Minister Johnson threatened to call an election in mid-October; his parliamentary majority appeared to slip away as the House of Commons voted to block a no-deal departure.

European equities partially rebounded in the second half of August. A late-month Group of Seven (G-7) meeting of world leaders in France featured a notable unscheduled visit by Iran’s foreign minister; his invitation by French President Emmanuel Macron showcased the gulf between European and US leaders in terms of how to proceed in the wake of US President Donald Trump deciding to exit the multi-party Iran denuclearisation agreement
last year.

Italy’s coalition government collapsed on the resignation of Prime Minister Giuseppe Conte, who stepped down in a move to block Deputy Prime Minister (and leader of the nativist League party) Matteo Salvini’s attempt to seize control though a snap election. At the request of President Sergio Mattarella, Mr. Conte has since agreed to help form a new coalition comprising the eurosceptic 5-Star Movement (the League’s former senior coalition partner) and the pro-EU Democratic Party.

US shares vacillated throughout August—confined to a total range of about three percent—and finished the month toward the high end, partially recovering from the early-month selloff. New tariffs went into effect on 1 September, imposing a 15% levy on $112 billion of Chinese exports to the US that were previously unaffected.

The US Treasury yield curve reached full inversion in August: The yield on the 30-year Treasury fell below the 1-month Treasury yield, settling at its bottommost level. The low-rate environment for long-term government bonds prompted US Treasury Secretary Steve Mnuchin to assert the possibility of issuing 50- and 100-year Treasurys. Long-term government bond yields declined by more than short-term yields in the UK and Europe as well.

Elsewhere, Argentina announced plans at the end of August to skip payments on more than $100 billion of debt in favour of comprehensive restructuring, sending prices on Argentine bonds spiralling downward. The Argentine stock market dropped 48% on 12 August—the largest single-day decline for a stock exchange since 19891—as primary election results indicated that President Mauricio Macri, a conservative reformer, would likely face pressure from populists in the upcoming general election. The government announced controls to restrict foreign purchases of Argentine pesos at the beginning of September.

India launched a wide-ranging occupation of Kashmir (a Muslim-majority region in the western Himalayas claimed by both India and Pakistan) in early August, which involved an expanded military presence, the imposition of curfews, targeted arrests, and a shuttered communications infrastructure. India’s Prime Minister Narendra Modi revoked Kashmir’s constitutionally guaranteed right to territorial autonomy on 5 August, raising the prospect of conflict between India and Pakistan—both of which possess nuclear arms.

Protests in Hong Kong that begin in early June continued to escalate incrementally throughout August, increasing the risk of a heavy-handed crackdown by the mainland Chinese government.

Central Banks

• The Bank of England’s Monetary Policy Committee announced on 1 August that it retained its preference for tighter monetary policy, contingent on Brexit and its impact on economic growth.
   
• The US Federal Open Market Committee (FOMC) did not meet in August, but announced on 31 July its decisions to cut the federal-funds rate by 0.25% and conclude its balance-sheet reduction program sooner than expected.
   
• Central Banks from New Zealand and a raft of emerging markets including India, Thailand, Mexico and Indonesia lowered their benchmark rates in August, collectively registering the greatest number of rate cuts in a single month since 2009.2 There was increased pressure on policymakers to ease monetary conditions due to the FOMC’s decision to cut the federal-funds rate and China’s allowing the yuan to depreciate.
   
• The European Central Bank (ECB) and Bank of Japan had no meetings in August.

Economic Data

• A survey of UK retail sales conditions found that orders to suppliers dropped in August at the fastest rate since December 2008.3 UK manufacturing activity continued to contract for the fourth consecutive month in August. The UK claimant count unemployment rate remained unchanged in July at 3.2%; the three-month average UK unemployment rate increased from 3.8% to 3.9% for the April-to-June period, while average year-over-year earnings growth jumped from 3.4% to 3.7%. The UK economy shrank by 0.2% during the second quarter, contracting for the first time since 2012, but expanded 1.2% year over year.
   
• The eurozone services sector continued to grow at a healthy pace in August according to a preliminary report. However, manufacturing activity declined for the seventh straight month. The eurozone unemployment rate held at 7.5% in July for the third consecutive month. Overall economic growth registered 0.2% during the second quarter and 1.1% year over year, unchanged from an earlier report.
   
• US manufacturing activity slowed in August as export orders tumbled. Personal incomes gained 0.1% in July and consumer spending jumped by 0.6%, as prices for personal consumption expenditures increased at a 1.4% year-over-year pace (1.6% for core prices, which exclude food and energy products). Total economic growth was less than expected in the second quarter, but measured an annualised 2.0% on robust consumer spending.

SEI’s View

July marked the tenth anniversary of the US economic expansion. The bull market in the S&P 500 Index reached its tenth birthday in March, and appeared to celebrate these achievements by moving into new-high territory through late July. But there now seems to be anxiety that the bull market in equities is on its last legs, the victim of a slowing global economy, the lagged impact of last year’s US interest-rate increases and, perhaps most importantly, a worsening trade war between the US and China.

To be sure, the US economy is hardly firing on all cylinders. There’s a good chance that capital spending will continue to ease in the months ahead, but we’re not forecasting a major downturn. Corporate cash generation continues to run slightly ahead of capital expenditures. The main point to remember: It’s not unusual for capital expenditures to run well in excess of cash flow, especially toward the end of the economic up-cycle. And that’s not happening yet.

We need to see a severe deterioration in financial and leading economic indicators before climbing onto the recession train. Even after the past two years of multiple FOMC rate increases, there are few signs of a build-up in financial stress.

The big unknown, of course, is how the evolving tariff war between China and the US will affect US economic growth and global trade in the months ahead. Tariff tensions and worries about global growth have put only a modest dent in the confidence of American businesses so far, but it certainly looks as if the US-China trade relationship is getting frostier.

It is our view at SEI that the US economy should be able to weather this storm. An all-out tariff war between the two largest economies in the world will certainly disrupt supply chains and likely lead to higher prices for a broad range of consumer goods. Still, we think it helps to keep the problem in perspective. Even if the US imposes a 25% tariff on all Chinese imports, total duties will amount to roughly 0.5% of US gross domestic product, according to our calculations of data provided by the US International
Trade Commission.

It is not our intention to minimise the importance of the shift in US trade policy toward protectionism. The speed and ease with which supply chains can be relocated to other countries will be a critical factor, either exacerbating or tempering the tariff impact on consumers and companies in both the US and China. An escalation of the trade wars by the US against other countries would prove far more dangerous for the near-term growth prospects in the US than if trade were disrupted only with China.

We have been thinking that the US would avoid waging multiple tariff wars as it concentrated its firepower on China. But our persistent optimism may not hold. Tariffs on German and Japanese autos are still a possibility later this year.

In all, we think the US economy will show resiliency in the face of what is admittedly a stiff headwind. Household income growth has continued to advance at a good pace. The decline in US interest rates that began late last year should certainly help consumers.

The market-implied US federal-funds rate (based on federal-funds futures contracts as at 30 August) is projected to be 1.6% by the close of 2019, according to the CME Group, consistent with two additional 25 basis-point cuts. Although the forecasts of FOMC members have been more cautious, they are moving in the direction of the markets. The recent decline in bond yields to levels last seen in 2016 ranks as one of the biggest surprises of the year. We find it hard to justify these moves. In our view, recession is not likely without a severe policy mistake, such as fighting a tariff war on multiple fronts.

When one considers all the headwinds facing emerging economies—a significant slowdown in Chinese economic growth, ongoing trade tensions between the US and China, weak commodity pricing, and a still-resilient US dollar—it’s surprising that emerging stock markets have appreciated at all this year.

Europe currently faces a variety of idiosyncratic challenges, both economic and political, that makes it hard for even contrarian investors to get terribly enthusiastic about the near term. Economically, the downward trajectory is similar to that of the 2011-to-2012 period amid the region’s periphery debt crisis. This time, however, Germany’s industrial economy is fully participating in the slowdown.

It’s not just the region’s heavy exposure to manufacturing and international trade that makes German industrialists glum. There is also a worrisome vacuum of political leadership. Chancellor Angela Merkel is on her way out, and a politically distracted Germany is a concerning issue given the country’s central importance in the eurozone and EU.

At the supra-national level, Christine Lagarde will succeed Mario Draghi as president of the ECB and is expected to maintain the dovish policies of her predecessor. But unconventional monetary policy in the form of negative European interest rates, quantitative easing and term lending facilities do not carry a lot of punch nowadays. An aggressive easing of fiscal policy makes sense, but that strategy is a non-starter in the eurozone. Once again, the structural flaws of the eurozone are coming to the fore.

And then there’s the looming cloud of Brexit. Although it has been delayed until 31 October, there is little sign that the breathing space will be put to good use. It’s hard to see how Boris Johnson’s ascension to the role of prime minister improves the chances of an orderly exit.

Although economic growth is sluggish, the UK economy is not exactly cratering as the deadline approaches. In fact, the UK unemployment rate fell to a multi-decade low. The eurozone also recorded steady labour-market improvement; yet the jobless rate itself remained far higher, owing to structural factors.

That said, we can’t help but think Brexit (if it indeed occurs) will prove to be a highly disruptive event for the UK and the EU. Roughly half of the UK’s trade in goods, both imports and exports, are with the EU.

We think there is still life in the economic expansion, both in the US and globally. If we’re right, corporate profits should continue to expand and push global stock markets to higher levels in the months ahead. This may seem like a bold statement at a time when the world seems increasingly unpredictable and the economic data signal slowing growth. Yet we simply do not yet see the economic imbalances or nosebleed equity-market valuations that normally bring on recessions and an associated contraction in earnings and stock prices. It is also clear that central banks have investors’ backs as monetary policymakers promise to (or already are) cutting interest rates in various parts of the world and providing additional liquidity to their banking systems in both developed and emerging countries.

Glossary of Financial Terms

Dovish: Dovish refers to the views of a policy advisor (for example, at the Bank of England) that are positive on inflation and its economic impact, and thus tends to favour lower interest rates.

Federal-funds rate: The federal-funds rate is the interest rate at which a depository institution lends immediately-available funds (balances at the US Federal Reserve) to another depository institution overnight in the US.

Quantitative easing: Quantitative easing refers to expansionary efforts by a central bank to help increase the supply of money in the economy.

Index Descriptions

S&P 500 Index: The S&P 500 Index is an unmanaged market-capitalisation-weighted index comprising 500 of the largest publicly-traded US companies and is considered representative of the broad US stock market.

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