Monthly Brief August 2019 – Interest Rate Policy & Economic Growth
With no shortage of conflicting information, who can blame global investors for being unsure in the back-and-forth markets experienced during the prior months. But the questions remain: Are ongoing global economic stimulus measures enough to support an increase in asset prices? Is uncertainty now high enough to reign in investor risk taking? Or are global economic conditions deteriorating to a degree that investors should reduce their holdings of risk assets?
As none of these questions is easy to answer, it’s no wonder that the high-profile US equity markets have essentially been flat for the last twelve months, as exemplified by the S&P 500 Index. But this path to nowhere has been quite volatile, highlighting investors’ heightened sensitivity to the latest economic reports, central bank comments and/or (sadly enough) tweets. Lacking clear trends, market moves have been quick to reverse course on speculation regarding trade talks, interest rate policy or the next economic report. Not surprisingly, this culminated with August’s back-and-forth, range-bound trading, an environment that often sets the stage for a new trend to exert itself. How might this be resolved?
Threats of slowing business activity continue to show up in the data. While not at recessionary levels, several measures would suggest business activity is continuing to slow. From CEO comments of concern while commenting on second quarter earnings reports to signs of deterioration in surveys conducted among various industries, it has become evident that the rate of growth in broad business conditions is generally slowing, but not yet contracting. Still, the consumer, a significant and important part of the global economy, continues to spend. And low global interest rates play into this equation through their impact on credit conditions, thus helping individuals (i.e. housing) and corporate entities (i.e. borrowing costs) manage expenses. The consumer’s resiliency looks to be a critical piece in the US economy’s ability to avoid the economic downturns experienced by many of our global counterparts.
The factors that have led to the choppy markets over the past twelve months are likely to persist until certain global economic issues are viewed to be moving towards a positive resolution. While the Federal Reserve may cut rates further, this tactic has not, on its own, prevented other countries from experiencing further economic deterioration. Can the consumer continue to supplement slowing business conditions and help to maintain modest economic growth? How this plays out will likely have a strong bearing on whether this period can be contained to an economic slowdown or a path to recession.
CHART OF INTEREST – Interest Rate Policy & Economic Growth
The US economic slowdown has been, in large part, triggered by the disruption in global trade. Should a resolution be found, markets are likely to initially respond positively, but will it be enduring? The longer the conflict persists, the more likely it is that the parties involved have developed solutions which are increasingly likely to be long-term, rather than stop-gap measures that can be easily unwound.
Global central banks have taken measures designed to potentially offset the impact of trade disruption on economic growth. First and foremost has been interest rate policy. The experiment in Europe has been to reduce policy rates to below zero, resulting in longer-term rates also going negative. (How interest rates can be negative is another discussion!)
Europe has had its own version of trade disruption with the overhang of Brexit. Looking at the European Central Bank’s (ECB) interest rate policy relative to Europe’s most stable economy, Germany, may provide some insight as to the effectiveness of using aggressive rate cuts to avoid an economic downturn.
The ECB’s Deposit Facility Rate now stands at -0.40% (the US Fed Funds rate currently stands at 2.5%). Unfortunately, as the chart shows, this approach has not been enough to stop further economic slowing. The top pane shows that the ECB has been reducing the Deposit Facility Rate since 2014. Yet the bottom pane shows how the German GDP growth rate was unable to be sustained and, while the German economy is still growing, the growth rate has been in decline since 2017. (While this chart of annualized data does show modest growth, the most recent quarterly report showed a contraction in second quarter GDP versus that of the first quarter in 2019.)
Could these policy measures have helped to keep the downturn from being worse? Possibly, but most would suggest that interest rate policy alone is not enough to bridge this gap of politically generated disruption in the global economy. And, it may result in a new set of issues when it’s time to unwind these aggressive measures. The US Federal Reserve would do well to consider the experience in Europe as they contemplate further interest rate cuts.
James Ferrin, CFA
Chief Investment Officer
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