Highlights

• While we see some key risks to the economic outlook—mostly centered on confusion over trade policy—we expect this economic expansion will continue.

•  A Fed rate cut on July 31 seems like a foregone conclusion, but we think forecasts for additional rate cuts beyond that are overly optimistic.

•  Investors should expect more limited returns from broad asset classes than they experienced in the past, making selectivity critical.

Equities fell last week with the S&P 500 Index dropping 1.2% (Source: FactSet, Morningstar Direct and Bloomberg). Investor attention was focused on the Federal Reserve, as one Fed official seemed to indicate the possibility of a 50 basis point rate cut next week before that statement was walked back to make it clear that a 25 basis point cut was more likely. For the week, consumer staples, technology and health care led the way while communications services, energy and consumer discretionary lagged (Source: FactSet, Morningstar Direct and Bloomberg).

Despite Downside Risks, We Expect The Economic Expansion To Continue

At this point, the United States has enjoyed the longest economic expansion in its history. But it often doesn’t feel like it since investors appear to be mostly focused on some of the key downside economic risks. Chief among those are the slowdown in manufacturing, trade issues and broader domestic and global political dysfunction.

A slowdown in both manufacturing and trade levels around the world has been a persistent source of concern. Starting last year, we have seen ongoing confusion and consternation over global trade policy, and especially over President Donald Trump’s volatile approach to threatening tariffs and moving in and out of negotiations with other world leaders. We view the mounting trade pressure from the U.S. as a threat to the global economy. The recent G-20 meeting was mildly positive, with the U.S. delaying another round of tariffs on Chinese goods and temporarily relaxing restrictions on Huawei. By itself, however, the outcome does not remove the overhanging threat to global growth. This was reinforced by the U.S. announcement of new, albeit small, tariffs against European goods.

As long as trade policy remains uncertain, corporate management teams will be reluctant to engage in new spending plans and capital investments, which has dampened manufacturing data. To some extent, we think the manufacturing slowdown is cyclical and has been caused in part by the lagged effects of Federal Reserve rate hikes that took place in 2018. We do expect to see a pickup in manufacturing by the end of the year, but also think trade-policy confusion will remain a drag on economic growth until at least the 2020 elections.

While trade is certainly the headline issue affecting investor sentiment, we are also concerned with a range of other U.S. and global political issues that could be problematic for the economy and financial markets. Political discord in the U.S. is growing. The risks of some sort of fiscal showdown this fall over the budget and debt ceiling are rising and ongoing investigations into the Trump Administration could well trigger additional uncertainty. Investors are also anxiously awaiting the 2020 election and what the results could mean for tax and regulatory policies. Globally, we’re also focusing on the growing prospects for a messy Brexit as well as potential flare ups in the Middle East and on the Korean peninsula.

Nevertheless, we remain cautiously optimistic that the expansion will continue. The labor market remains strong, consumer spending is solid and the Federal Reserve remains highly accommodative—more on that point in the following section. Especially if global manufacturing picks up, we think the slow expansion will continue and do not see the sorts of imbalances that would trigger a recession.

We Expect The Fed Will Ease, But Not As Much As Markets Anticipate

Central bank policy around the world has shifted decisively in recent months to provide additional monetary support to fuel economic growth. Financial markets have certainly welcomed this seemingly open-ended accommodative commitment from central banks, as evidenced by the fact that U.S. stocks once again reached new record highs. The key question for investors is whether easy monetary policy will be able to reverse the current economic soft patch.

At this point, it is all but certain that the Fed will cut rates at its end-of-July meeting. That’s already reflected in market expectations. But what will the Fed do after July? Many investors expect that the Fed will engage in a prolonged cutting campaign, and market expectations are for multiple cuts this year alone. But we doubt this is the case. Following the July meeting, we expect the Fed will adopt a wait-and-see approach. If economic data weakens, more cuts could come, but given we remain in an environment of below-4% unemployment and slow-but-positive wage growth, it’s hard to make the case for an extended easing cycle. There is certainly a risk that the Fed could disappoint by “only” cutting rates once.

Equities Look Less Appealing, But So Do Other Asset Classes

While our best bet is that the economic expansion will continue, the investment climate is becoming less appealing. Indeed, even if the trade threat diminishes, it is unclear whether an upturn in manufacturing and trade would be sufficient to spark a sustained rise in stock prices. And we also think investors are betting too hard on prospects for multiple interest rate cuts.

U.S. corporate business profitability (return on equity) already looks elevated by historical standards, which means it is hard to see how U.S. companies can achieve much more earnings upside in the current cycle. And valuations are certainly much fuller than they were at the start of the year. Prospects for earnings growth appear better in the rest of the world, but global economic growth would have to surprise on the upside for significant earnings growth to occur.

And the issue for investors is that other asset classes also offer dicey prospects. Given current yields, developed market government bonds look unattractive unless the world enters a recession. And many areas of the fixed income credit markets appear to offer limited upside in absolute terms even in a benign economic climate. Gold has broken out to the upside, but unless the U.S. dollar experiences a significant devaluation, it is hard to get excited about commodities in aggregate. And cash still offers relatively low yields.

As a result, we think the current environment will remain one in which selectivity and flexibility are critical—across all asset classes. Within equities, this means focusing on companies with the ability to generate free cash flow, those that have pricing power or other competitive advantages and those that are positioned for an eventual modest upturn in economic growth.

Robert C. Doll, CFA, is chief equity strategist and senior portfolio manager at Nuveen.