Good night, and good luck

By David Rubin, Senior Managing Director, Capital Markets, Kevin Holme, Managing Director, Capital Markets

What can you learn from last year and how can you prepare for the year to come?

Thus did the iconic journalist Edward R. Murrow sign off his radio and television broadcasts over the course of his historic, clear-eyed, and distinguished career. We thought it was a fitting line with which to bid farewell to a tumultuous year and look to the year ahead.  

Today’s Fed Decision
Well, what looked like a foregone conclusion a few weeks ago no longer seemed like such a cinch going into this week’s Fed meetings. Against the backdrop of market volatility and a flurry of tweet storms, as well as worried op-eds in the financial press, Fed Chair Jerome Powell found himself in a tough spot leading up to his announcement today.

In the end, as most market professionals expected, the Fed voted unanimously today to raise the target range for the federal funds rate by 25 basis points to a range of 2.25% - 2.50%.  In a nod to the dovish camp, the Fed added the phrase that it “will continue to monitor the global economic and financial developments and assess their implications for the economic outlook.”

With 2019 in mind, we report on issues that will likely shape the direction of rates and Fed policy:

1. Domestic Politics
As last week’s heated discussion in the Oval Office suggests, it’s going to be a new ballgame between Congress and the White House going forward. Add in the expected report from Special Counsel Robert Mueller, along with the unofficial kickoff of the 2020 campaign, and the table will be set for some potential Capitol Hill chaos. Markets typically don’t like uncertainty or choppy air. Time to buckle up.

2. Geopolitics, Trade, and Oil

  • China
    Is this a war over tariffs and market access, or something much more fundamental? Is it really a battle over technological ascendancy and competition for spheres of influence – and a return to a bipolar world order, with the United States facing off against China? We believe it’s the latter, which will have significant implications for U.S. exporters to China—manufacturers, the agricultural sector—as well as for capital flows (China remains the largest foreign holder of U.S. Treasury securities).

  • North Korea
    Maybe the easing of tensions was premature after all. Nukes have a way of focusing the mind and Chairman Kim may still be on that path. With a North Korean leader as unpredictable as Kim, keep your eyes on a flight to safe-haven assets if tensions start rising again between the U.S. and Pyongyang, as this would likely push down interest rates but would also depress equities and create much uncertainty for investors overall. 

  • Middle East and the Gulf
    MBS (Saudi Crown Prince Mohammed bin Salman) has now entered the popular lexicon for all the wrong reasons. The U.S.-Saudi relationship has been a pillar of American policy in the Middle East since World War II. It is arguably one of shared interests rather than shared values. The question is whether those shared interests are changing and diminishing. That notwithstanding, the U.S. does share one interest with the Saudis and some of its neighbors—containing Iran’s drive for regional hegemony. The U.S. has made a long bet on the stability of the House of Saud in this regard—MBS may be a monkey wrench in this policy strategy. Other issues that could easily escalate include tensions along Israel’s borders (Gaza, Lebanon, and Syria), the seething discontent in Egypt under the current regime, and the continuing descent of Turkey into authoritarian rule under Recep Tayyip Erdogan. The potential market impact would be very similar to instability on the Korean peninsula—flight to safe havens in response to uncertainty and turmoil.  

  • Europe
    Where to begin? Brexit, France, Germany, Italy? The four most important economies in Europe are undergoing deep political unrest. The UK economy will likely go into recession as Brexit redefines the meaning of a messy divorce. Emmanuel Macron’s hold on power is under assault and it’s only a matter of time before the populist right moves to exploit it. With the end of the Merkel era in Germany coming into focus, much uncertainty lies ahead. Italy is dealing with its own economic issues and is showing signs of moving to the right. Meanwhile, Vladimir Putin dreams of old maps, particularly those that show Ukraine as part of the Czarist and Soviet empires. He also has his hand on the supply valve for natural gas for much of Western Europe – is a cold winter in store?

  • Mexico and Latin America
    Mexico is a vitally important trade partner of the United States. In 2017, total trade between the two countries was $616 billion; that compares with total 2017 U.S. trade with China of $636 billion. If everyone knows who MBS is, they better get to know who AMLO is too—Andrés Manuel López Obrador, the new president of Mexico. Plenty of other currents are roiling the rest of Latin America—Venezuela is in catastrophic collapse and Brazil just took a hard turn to the right in its most recent presidential election.  

  • Oil Prices
    Oil production has been booming both in the U.S. and internationally, far outstripping demand and causing prices to plummet. There is an important correlation between oil prices and the yield on the 10-year U.S. Treasury. Oil drives transportation costs which, in turn, have a big impact on inflation. A decline in oil prices puts a lid on inflation, which in turn puts a downward bias on bond yields.  MBS and Putin may have been grinning and pumping handshakes at the G20, but they’re actually worried, and the Saudis and the Russians have pushed OPEC for steeper cuts in output—they need higher prices over time. As of this writing, market participants are skeptical about the proposed cuts being enough to stabilize prices.

3. Death, Taxes, and Other Things That Matter

  • Living Shorter Lives?
    A startling headline crossed the news wires a week or two back: U.S. life expectancies had declined for the second year in a row. Analysts point to increased opioid addiction and other substance abuse, as well as an ongoing increase in suicides. These are indicators of despair among a significant swath of our population and may also point to the uneven economic recovery of the past decade. This is a very troubling indicator on many levels, with potential ramifications for labor force participation and economic growth among them. 
  • Taxes
    Was the tax overhaul a sugar high that’s run its course? Indications on the corporate side are that tax savings have not led to the expected jump in investment spending. Lots of cash is still building up on balance sheets instead, much of it still offshore. Consumers have benefited as reflected in spending levels, but it remains to be seen if this is a one-time bump.

  • U.S. Employment and Growth
    The unemployment rate continues at the lowest rate since 1969. But there are some potential cracks in the foundation. For example, payroll job growth averaged 204,000 over the past year, 195,000 over the past six months, and 170,000 over the past three months.   

    While these are still excellent growth numbers, the slowing trend could be cause for concern. Anecdotal evidence also bears watching. General Motors recently announced 60,000 job cuts highlighted by the planned shutdown of several plants. Also, layoff notices as compiled by Challenger Gray & Christmas are up almost 30% from a year ago.

    The overarching question is when and how slowing growth in other major economies (the UK, Europe, China) will impact growth in the U.S.; we are not alone in the global economy. 

  • The Return of Volatility–Follow the Money 
    Equity markets have demonstrated great volatility over the past quarter. Some of this is clearly attributable to investors rotating to interest-bearing assets as rates have moved higher. Others have viewed the backdrop of instability as a signal to take their gains and seek safer havens. Monetary authorities, whether the Fed or other central banks, have pushed investors toward risk assets for much of the past decade since the financial crisis. As they work to finally normalize monetary policy through rate increases and balance sheet reductions, this is an expected consequence. Particular attention should be paid to balance sheet reduction by central banks (the reversal of quantitative easing), and its impact on asset prices and market volatility. Withdrawal from a decade of addiction to financial opioids is going to be rough for many.   

So where to from here?
We’re tempted to say, who knows? Today’s interest rate decision was not as certain as previously anticipated. On a certain level, the Fed had to increase today if only to reassert its independence in the wake of the president’s criticism of Chairman Powell. Looking out over 2019, it is fair to assume we will still get multiple Fed rate hikes, likely two rather than the previously expected three moves as the Fed consensus dot plot dropped from three to two hikes in 2019 and one more in 2020 and none in 2021.

While it is likely U.S. growth may slow next year, the Fed expects it to remain above-trend, and to continue pressing the unemployment rate lower. Furthermore, although the stock market sell-off and other factors (weaker auto and housing markets) present some downside risks to the economy, we continue to believe recession risks are low over the cyclical horizon. Strong U.S. household balance sheets and well-capitalized banks are important buffers against negative economic shocks. The Fed will be data-driven and they will have a very close eye on those factors outside the economy that could slam the markets. The Fed doesn’t operate in a vacuum—a point made by Chairman Powell in a speech on November 28, and again today. The Fed will measure carefully the impact of its policy moves.    

So what’s the bottom line? We continue to advise clients to prepare for the unknown and preserve flexibility—stuff happens. Long term interest rates have moved lower recently and offer borrowers well-priced hedging tools to both control interest expense and preserve optionality. We advise our clients to consider the many alternatives that go beyond the normal fixed-rate swaps and loans, such as interest rate caps, collars, and swaps with embedded cancellation options. We would be pleased to discuss how we can help your business navigate the rate environment going forward, so call your relationship banker or us directly.

Good Night, and Good Luck
So as we close out the year, we circle back to Ed Morrow—to all a good night. As for good luck, we invoke Branch Rickey, who pointed out that luck is the residue of design. Either way, we wish you good luck as well as our best for the holidays and a happy, healthy, fulfilling, and peaceful New Year.