The US economy is slowing, as corporations and consumers confront the blowback from intensifying trade conflict, which has triggered a global manufacturing recession. Until recently, weakness was confined to the industrial sector, but is now spreading to the services economy. The Fed has made two precautionary rate cuts in an effort to forestall recession, and has promised to do more if the economy continues to weaken.
Corporate earnings are in sequential decline as we enter the fourth quarter. The combination of weaker overseas demand, a strong US$, and rising domestic labor costs are pressuring margins. The stock market has remained elevated thanks to low interest rates, which continue to fuel debt-funded stock buybacks. The passive investing juggernaut has also buoyed the market—although many segments are performing poorly. Both passive investing and stock buybacks are liquidity-dependent, price-insensitive, and increasingly divergent from fundamentals.
A continuation of the Federal Reserve’s easy-money policies cannot prevent recession in an economy that is fully-loaded with debt. There is no evidence that business capital spending responds to changes in interest rates, and most US households cannot afford to borrow much more. The central bank has abused its “exorbitant privilege” of issuing money to drive up asset prices, worsening a wealth divide that is becoming politically contentious.
Leaders in the policy, academic and financial communities are beginning to question the wisdom of continuing with a monetary strategy that is at best ineffective, and at worst counterproductive. Unfortunately, most central bankers have been unwilling to acknowledge that their policies are no longer working. We fear a loss of Fed credibility that could spiral into a crisis of confidence when the Emperor is seen to be naked.
We doubt the Fed will experiment with negative interest rates, as have been tried in Europe and Japan. It is more likely that public opinion will induce the central bank to shift its focus away from the financial sector and toward the real economy. Modern Monetary Theory is just another name for the “helicopter money” Fed Chairman Bernanke proposed several years ago. Printing money into the hands of ordinary people and businesses is better than the “socialism for capitalists” we have seen in recent decades. That said, it is a poor remedy for the political and governance failures that have brought us to this point.
US stocks have delivered a total return since early 2018 that is barely above gains in the bond market. Paladin client portfolios remain underweight US equity, with a tilt toward high-quality value stocks. We remain overweight short-duration bonds and cash, as we survey the international landscape for attractively-priced equity investments. We have taken profit on our long US$ and gold investments, and have deployed alternative portfolio hedges including a long position in the Japanese yen.