Read the weekly economic commentary from Chief Economist Scott Brown.
October 24, 2018
Periods of low market volatility (or complacency) are often followed by turbulent readjustments, including sharp intraday moves lower and higher. There has been a long list of concerns in the last few months: the November 6 election, tighter Fed policy, higher long-term interest rates, trade policy disruptions, risks to the global economy, labor market constraints, and so on. The stock market often climbs a wall of worry, sometimes you hit the wall. The near-term economic outlook remains optimistic, but there is also a vague pessimism about 2019 and 2020. We can expect to bounce between these views.
Elections are best viewed as a probabilistic event. Polls generally reveal preferences, but there is sampling uncertainty. Turnout is hard to predict. Nate Silver’s 538 website provides a comprehensive assessment of polls and offers probabilities for House and Senate races. Nate Silver is the man. While most pundits predicted that Hillary Clinton would win the 2016 presidential election, Nate put the odds at about two in three – which means that Trump had a one in three chance of winning (far from 0%). Currently, the 538 website shows an 85% chance that the Democrats will gain control of the House (all 435 representatives are elected every two years). Serving six-year terms, a third of Senators are up for election every two years (35 seats this year) and Democrats are playing defense (23 contested seats are currently held by Democrats, 2 are independents who normally side with Democrats, and 8 are held by Republicans). The 538 website places the odds of the Democrats gaining control of the Senate at 19% -- not out of the question, but very unlikely. So, a split Congress should be already factored into the financial markets.
What would a split Congress mean for the economic and market outlook? A Democratic-controlled House would be expected to conduct hearings on a wide range of issues involving the Trump administration, but that would be unlikely to lead to any significant policy changes. The House would not, by itself, be able to raise taxes or alter much of regulatory policy (which falls mostly under the Senate). A Democratic-controlled House could vote to impeach President Trump (which means he would be put on trial in the Senate), but it would take a two-thirds majority in the Senate to remove Trump from office. Hence, investors should not fear the current election expectation (of a split Congress). There is a small chance that the Democrats could gain control of both chambers, and that would be a different story, but that is a low-probability outcome (a longer shot than Trump winning the White House).
The impact of trade tariffs has continued to broaden, but the overall impact on growth and inflation appears to be relatively limited. An increasing number of firms are reported input price pressures, although the Producer Price Index indicates some moderation following sharper increases in the first half of the year. Soybean exports appear to have been boosted in 2Q18 (adding to GDP growth), ahead of Chinese retaliatory tariffs, leading to a pullback in 3Q18 (subtracting from GDP growth). In contrast to the first round of tariffs on Chinese goods ($50 billion, imposed on July 6 and limited mostly to industrial inputs), the second round ($200 billion, imposed on September 17) included industrial inputs, capital equipment, and some consumer goods. Those tariffs, currently 10%, are set to rise to 25% on January 1, which would have a more substantial impact on consumer spending and inflation heading into the important spring retail season. President Trump has also threatened to impose tariffs on an additional $267 billion in Chinese goods, which would hit the consumer sector even harder. The U.S.-Mexico-Canada Agreement (USMCA) has reduced some trade policy uncertainty, but the impact on the auto industry is unclear (Trump has threatened to impose tariffs on auto imports).
Fed policymakers continue to view trade policy as a downside risk to the U.S. economic outlook, but officials seem willing to wait for more evidence of the impact before adjusting policy expectations. As the federal funds target rate nears a neutral level, the risks of a policy error increase. This has been the central focus for Fed officials in recent months, and the consensus at the Fed is that the gradual approach to raising rates best balances the risks of moving too slow or too fast. Monetary policy decisions will remain data dependent – specifically, since monetary policy must be forward looking, it is what the data imply for the outlook for growth and inflation. However, financial conditions also play a role. All else equal, stock market softness implies that the Fed would be somewhat less likely to raise short-term interest rates – but that depends on the magnitude of the decline, how long it lasts, and whether it feeds through to the real economy. The stock market is just one of many factors in the Fed’s decision making.
Bond yields have been pressured by a variety of forces: strong growth, (somewhat) higher inflation, increased government borrowing, tighter monetary policy, and (to a small extent) the unwinding of the Fed’s balance sheet. However, long-term interest rates abroad remain low, limiting the rise in U.S. bond yields. While the rise in long-term rates has contributed to the stock market readjustment, the drop in the major stock market indices has boosted bond prices (lower yields) in the short run. Still, rising mortgage rates won’t help the housing market, which has been under some pressure due to affordability issues.
Readjustments are a natural (and welcome) part of financial markets. The key is always whether the adjustment has a significant effect on the real economy (most likely, not). We are never “due” for a recession, but the table is typically set for an economic downturn through over-investment or a misallocation of capital. We’re not there yet, but it’s something to watch out for.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.