Highlights

• Stock markets have been rattled by plunging bond yields that are showing recession signals. In our view, yields have fallen too far and we don’t think a U.S. recession is imminent.

• At the same time, however, we are increasingly concerned by the deterioration in the U.S./China trade war, and think economic and market risks are rising.

After a brief relief bounce on hopes that the U.S. might be trying to ease tensions with China, the equity market downturn resumed last week as investors left stocks for the perceived safety of government bonds. Recession-related concerns grew as the Treasury yield curve inverted, more global government bond markets traded in negative territory and poor economic data came out of Germany and China. For the week, the S&P 500 Index fell 0.9% amid high volatility.¹

Weekly Top Themes

1. Bond yields may have overshot their mark. Over the past 12 months, the 10-year Treasury yield has fallen more than 150 basis points, including nearly 20 basis points in just the last week.¹ The 10- year currently yields 1.56%, significantly lower than the 2.25% fed funds rate.¹ These prices suggest the U.S. is facing imminent recession and possible deflation, neither of which seems likely. As such, we think yields have fallen too far, too fast.

2. The U.S. consumer remains an important source of strength. Retail sales expanded a healthy 0.7% in July.² We expect consumer spending will be up by 2.5% to 3% in the third quarter, which would significantly help overall economic growth.

3. The U.S. economy has remained relatively resilient to trade issues so far. With the U.S./China trade war now about one year old, the U.S. consumer sector and labor market remain solid. To a large extent, this is due to the relatively isolated nature of the U.S. economy: Among all developed nations, the U.S. has the lowest percentage of its economy based on trade.³

4. There are massive underlying complexities driving the U.S./ China trade war. In addition to struggles over intellectual property, the countries also engage in competition over technological innovation. Consider the rise of 5G, the fifth generation of mobile technology intended to connect computers, phones and other devices at speeds that are 10 to 100 times faster than the current 4G networks. Huawei is one company making equipment that will enable these 5G networks. U.S. restrictions against Huawei appear to have a lot to do with the fact that no U.S. companies are currently engaged in 5G networking.

5. Europe appears overly dependent on monetary policy to solve its economic woes. The European Central Bank adopted a negative interest rate policy more than five years ago to address economic weakness. Now Europe is struggling, with the latest evidence being a sharp 5% drop in German industrial production in June, the largest decline since the Great Recession.⁴ In our view, Europe must address fiscal imbalances and regulatory policies for the eurozone economy to get back on track.

Economic And Equity Risks Appear Tilted To The Downside For Now

Trade-related risks seem to be growing. President Trump looks to be holding out hope that the U.S. economy will stay resilient in the face of escalating tariffs and rising tensions. So far, the U.S. economy has not faltered, thanks largely to continued strength in the consumer sector and labor market. But if business confidence crumbles (as it has in parts of Europe), it could lead to serious economic damage. It doesn’t help that trade issues are escalating while other regions remain uncertain, such as the heightened odds of a no-deal Brexit and political turmoil in Hong Kong.

The president’s recent actions to delay the implementation of some new tariffs show that he is sensitive to the market impact of his trade policies. But the erratic nature of his on-again, off-again approach adds too policy uncertainty. At this point, we can’t predict the ultimate economic impact from these issues. Our best guess is that the U.S. remains more than a year away from the next recession, but risks are rising. In addition to the solid consumer sector, we don’t see financial stress in the system. Liquidity is still broadly available, and fixed income credit spreads are generally stable outside of the energy sector.

With additional Federal Reserve rate cuts already priced into the markets and bond yields falling sharply, the only catalyst for better equity market performance could be improving global economic data. We hold out hope that the global economy will improve, and still think there is a better-than-even chance of manufacturing activity and export levels to grow. But those improvements will take some time, suggesting equities will remain volatile and vulnerable for now.

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

 

¹ Source: FactSet, Morningstar Direct and Bloomberg
² Source: Commerce Department
³ Source: World Bank
⁴ Source: German Economy Ministry