THE FEDERAL RESERVE, CHINA, AND RECESSION RISK-A LOOK AT WHAT’S IMPACTING THE MARKETS AT YEAR-END

1
THE FEDERAL RESERVE, CHINA, AND RECESSION RISK A
LOOK AT WHATS IMPACTING THE MARKETS AT YEAR-END
As we near the close of 2018, its hard to ignore
the juxtaposition from 2017, when the capital
market environment experienced a broad increase
in most asset classes, accompanied by remarkably
low volatility. Fast forward to the present and,
according to Deutsche Bank, nearly 90 of the 71
asset classes they track were down as of the end
of Octoberthe worst breadth since the 1905 start
of the data series. Even with the recent modest
late November/early December rally, 2018 is on
pace to post the first down year for both global
equities and the Barclays Aggregate Bond Index
in the last 25 years.
2
As we approach 2019, here are three things we are
monitoring most closely The Federal Reserve 
Dont fight the Fed has probably been the
dominant feature of financial markets since the
2008 Financial Crisis era. Thats been
particularly true since former Chairman Bernanke
penned his rather remarkable op-ed in the
Washington Post in early 2010 stating that a
primary goal of Fed policy would be to boost the
stock market to help stimulate a wealth effect.
Extraordinarily low interest rates both in the US
and throughout much of the world helped to do
just that amidst unprecedented monetary
stimulus. Of course, Quantitative Easing has now
morphed into Quantitative Tightening in the US,
with other countries potentially not far behind.
After several false starts (e.g., QE1 morphing
into QE2 and then QE3), the US has made notable
progress in starting the inevitable tightening
process with six rate hikes in the last two
years, along with the beginning of the
long-awaited reduction in the Fed balance sheet
earlier this year. The Fed has generally avoided
any sudden surprises in appreciation of the
still-tenuous state of global marketshence the
strong reaction to Powells seemingly
off-the-cuff statement during a PBS interview on
October 3 that rates were far from normal,
probably (and the dramatic positive response to
his reversal on November 28 when he stated that
rates were just below neutral).
3
We are hard-pressed to see sustained inflation
pressures in the economy, a view that has likely
been reinforced in the near-term by a steep
decline in crude and other commodity prices.
While the Fed governor dot plots currently call
for four 25 basis point rate hikes by the end of
2019, we expect no more than two, including one
this December. There are other overarching
characteristics that we believe argue for a more
dovish Fed posture, including the fact that
non-financial corporate debt stands at near a
post-WWII high of over 45 of GDP and
covenant-lite loans account for 80 of new loans
arranged by non-bank lendersmore than double the
2007 level of 30. China/Trade Tensions  The
best news on the trade front is that unlike
earlier in the year when trade uncertainty
included the EU, Canada, Mexico, Japan, South
Korea, and others, the concerns have now been
largely ring fenced to China (yes, there is some
risk that tensions resurface in at least some of
those other locales if tentative agreements are
not ratified). Of course, the more concerning
news as President Trump went to Argentina for
last weekends G20 summit was that the US and
China remained at loggerheads. While President
Trumps public views on several issues have
changed over the course of the last several
decades, he has been steadfast in his belief that
China has been among the countries that have
taken advantage of the US in trade and
intellectual property theft.
4
Our initial take is that the Trump/Xi talks went
about as well as one could have realistically
hoped in that the two leaders seem to share a
desire to reach some form of accommodation. A
cease fire clearly beats escalation into a
full-blown trade war. Still, a 90-day cooling
off period does not buy much additional time
before harder decisions will have to be made.
Moreover, it is still unclear exactly what
tentative understandings may or may not have been
reached at the summit given the inconsistent
statements issued from both the US and Chinese
sides. What is clear is that the talks come at a
critical time for global economic growth given
the slowdown in China this year and the
escalating fears of a so-called Chinese hard
landing. It is probably a bit of hyperbole to say
that a failure to bridge the US/China divide
would result in some form of mutually assured
economic destruction, but the incentives are
certainly there for the two sides to eventually
reach an agreement. The US is highly unlikely to
get the kind of intellectual property reforms it
desires. Moreover, we highly doubt that China
will significantly curb the key elements of the
high profile Made in China 2025 policy.
However, increased Chinese imports of US goods
(with lower tariffs) and some degree of enhanced
cooperation regarding North Korea strike us as
realistic sources of compromise. While this is
not a conventional US presidency, US presidents
typically turn more pro-growth after the
midterms and it is certainly possible that GOP
losses everywhere but the Senate will encourage
President Trump to move back toward Art of the
Deal mode in early 2019.
5
Recession Risk  In very broad and basic terms,
economic slowdown/recession fears matter because
they almost inevitably lead to earnings
disappointments. Indeed, bear markets are almost
always accompanied by recessions (there are rare
instances when one could argue that a bear market
caused a recession, such as in 2001 following the
technology/internet crash). The US is less than a
year away from posting the longest period of
economic expansion in its history, even if the
magnitude of the expansion has been
unexceptional. At this time, we believe the
probability of a US recession in 2019 is low but
not insignificant. The New York and Cleveland Fed
currently put the risk at 20 and 14,
respectively. This reflects generally robust
leading economic indicators, including employment
trends, consumer spending, consumer confidence,
consumer debt, ISM purchasing manager data, money
supply, and business confidence. Other relatively
benign indicators at present include wage growth,
retail sales, profit margins, and truck
shipments. As always though, there is a
proverbial laundry list of factors that bear
watching, including some recent signs of stress
in credit markets (e.g., the flattening of the
yield curve, widening spreads, an abundance of
at risk BBB debt) the slowing housing market
(history says that lightning rarely strikes twice
in the sense that the cause of the previous
downturn is rarely the cause of the next
downturn) European
6
political problems (Italy and Brexit in
particular) the stress on various Emerging
Markets from a generally robust US dollar and
the recent decline in oil prices (seemingly due
more to fears of excess production than to the
more concerning macro implications of falling
demand). Of the concerns noted above, we are
closely watching the flattening of the yield
curve. An inverted yield curve has preceded every
modern US recession, although there have also
been several false positives. Since peaking a
few weeks back near 3.25, bond yields havent
made much progress and the 2/10 curve has resumed
its flattening trajectory (currently at less than
15 basis points, the lowest since
2007). Article Source- https//athenacapital.co
m/blog/the-federal-reserve-china-and-recession-ris
k-a-look-at-whats-impacting-the-markets-at-year-en
d/