The wind has turned in the US and, as is often the case in the world’s biggest market economy, it was the stock market that proved to be the weathervane. Over the final three months of 2018, equity prices fell by 15%; whilst not a crash, this is a serious correction, which anticipates a likely normalisation of company earnings[1].
Blowback
Growth and inflationThere is little here that is surprising. With the effect of tax cuts waning, President Trump’s trade war is claiming its first victims among US companies. In December 2018, the index of new industrial orders lost 11 points, registering its biggest fall since that triggered by the collapse of Lehman Brothers a little over ten years ago (Chart 2). In the industrial and exporting region of Philadelphia, the Fed’s surveys suggest that expectations are less favourable.
With the price of oil dropping 25%[2], the energy sector is also feeling the pain. Highly leveraged, it is seeing tougher financing conditions (its risk premium is widening) and equity valuations falling. The immediate effects have been brakes on investment and production of oil and gas from fracking, which had set new records in 2018; these will be viewed differently depending on the importance one places on energy transition (see our article on page 24).
As mortgage rates rise, the real estate sector declines. The National Association of Home Builders (NAHB) index has lost ground, auguring over time a fall in housing starts and a correction in prices. Support will not come from the federal government, which, unhelpfully, is under a partial shutdown (see Box). This shutdown is already the longest ever, and will trim between USD5 billion and USD10 billion off economic activity each week[3]; its effects were not particularly visible at the end of 2018 but will be felt in the first quarter of 2019, when growth (at an annualised rate) will be trimmed by nearly one point.
A change in tone from the Fed
A sudden chillHaving made nine successive increases in the fed funds rate, taking it to 2.50% (upper limit), the Federal Reserve is now hinting at a pause. Even before the shutdown, members of the Open Markets Committee had tempered their economic diagnosis and their estimates of interest rate increases. Minutes from their last meeting (on 12 December 2018) suggest a cautious and watchful position, faced with feedback from business leaders in the field and imponderables such as Brexit, which the Fed has indicated it is following closely[4].
Flattening outThis change of tone has had its effects on the markets; for 2019 the forward yield curves suggest no monetary tightening but rather a status quo, or even a slight relaxation; in the sovereign bond segment, yields have fallen whilst the distribution across maturities has become nearly flat (Chart 3).
The longest shutdown in history In the past, such a pattern has always presaged a slowdown in the US economy, and it is unlikely that this time will be any different. The flattening of the yield curve increases the carrying cost of debts and contributes to the inversion of the leverage effect, something that the US has made significant use of in recent years[5]. For a number of quarters now, the International Monetary Fund (IMF) has warned of increasing vulnerability of certain sectors of the economy such as energy, infrastructure, healthcare and telecommunications (IMF, 2018)[6]. The IMF indicates that the latest wave of corporate debt issuance not only set new records, but also carries the greatest risk. In 2018, 80% of issues subscribed by institutional investors (mutual or pension funds, insurance companies, etc.) were ‘covenant lite’, that is to say virtually without any guarantee. Half of leveraged lending was issued at multiples of at least five times annual operating income.
A widening trade deficit
Some USD45 billion in additional import tariffs have been applied since 2018; the US administration could go even further in 2019. On 17 February, the Department of Commerce will deliver its conclusions on the “threat to national security” represented by vehicles manufactured in the European Union, potentially opening the way to additional tariffs. On 1 March, tariffs on Chinese goods could be raised further. To what effect?
The tenuous link between tariffs and the trade balance has already been discussed on these pages[7]. And indeed, the increase in tariffs has, so far, done nothing to reduce the trade deficit. Quite the opposite; the trade deficit excluding oil widened over the final months of 2018. The 12 months cumulated deficit in October was USD800 billion, a record high. Ironically, the biggest increase came in the deficit with China, the country hit the hardest by far by new tariffs. Might this fact dissuade President Trump from going further in his trade war? One might hope so; but hope may not be enough.
