The purpose of our Midyear Outlook 2019 is to provide you with our updated views of the current fundamentals at the halfway mark and the things that should persist as shorter-term concerns fade, and the markets continue emphasize our four primary pillars for fundamental investing — policy, the economy, fixed income, and equities. Today we will focus on Policy…

Policy

While fiscal policy has taken the lead, monetary policy grew more supportive in the first half of 2019. The Federal Reserve (Fed) indicated earlier this year that it would likely hold on raising interest rates for the rest of 2019, partly in response to the market’s poor reaction to last December’s rate increase. With inflation low, global growth slowing, and trade risk still present, monetary policy may be too tight for the current environment. Even if not fully justified by the data, the Fed may choose to lower rates later this year to provide a buffer against increased uncertainty.

Fiscal stimulus, via the Tax Cuts and Jobs Act of 2017, provided a boost to economic activity in 2018 through tax relief for consumers. We still believe that the fiscal support from the Act will exceed consensus expectations in 2019. Fiscal policy’s contribution to real GDP growth should be about 2.2% for 2019, higher than the 1.3% contribution in 2018.

Where We Are Now

We believe fiscal stimulus from the Tax Cuts and Jobs Act of 2017, along with decreased regulation and increased government spending, will continue to support the U.S. economy for the remainder of 2019, and that the potential impact is both larger and more durable than consensus expectations. At the same time, uncertainty around global trade continues to dampen the benefits of fiscal support and may be discouraging productivity-enhancing capital investment. We still believe self-interest is likely to bring the United States and China back to the negotiating table, but until we see progress, trade tensions remain one of the primary risk to our forecasts.

Current Outlook

Central bank–driven monetary policy and legislatively driven fiscal policy provide a constant backdrop against which businesses and consumers operate. Even though businesses drive much of their own success or failure, they’re always adjusting to policy environments. Consumers are also constantly nudged by policy, whether through interest rates, tax policy, or the overall job market.

Monetary policy has dominated much of this expansion, but over the last few years, fiscal policy increasingly has impacted businesses and the overall economy. Fiscal policymakers use four primary levers to support economic activity: taxes, regulation, spending, and trade. The first three levers remain tailwinds for economic growth and corporate profits. Trade, however, continues to dampen the benefits of the other levers.

Fiscal stimulus, via the Tax Cuts and Jobs Act of 2017, provided a boost to economic activity in 2018 through tax relief for consumers. We still believe that the fiscal support from the Act will exceed consensus expectations in 2019. Fiscal policy’s contribution to real GDP growth should be about 2.2% for 2019, higher than the 1.3% contribution in 2018. Reduced regulatory burdens have also increased business investment by energy companies, while looser capital standards have boosted the lending capacity of U.S. financial companies. Over the past year, U.S. corporations have repatriated approximately $750 billion of foreign-sourced profits, providing additional funding for shareholder distributions, hiring, and capital investment.

Trade, Tariffs & the Deficit

Unfortunately, the benefits of these fiscal measures may not fully materialize given heightened trade uncertainty. Too many businesses have faced questions about costs, logistics, and supply chain management to take advantage of incentives for capital investment.

Trade negotiations with China hit a stalemate in the middle of May, with the Trump administration responding by increasing tariffs to 25% (from 10%) on $200 billion in Chinese imports and threatening tariffs on the remaining $300-plus billion. China retaliated with additional levies of 25% on $60 billion in U.S. imports and threats of non-tariff barriers. In addition, the U.S. plans to impose tariffs on Mexican imports rolled markets in May but was quickly resolved. Nevertheless, businesses are increasingly concerned that a new front in the trade war could appear at any time.

In addition to trade, we remain concerned about the level of federal deficit spending. A glut of U.S. Treasuries have been issued over the past year to fund government spending under the assumption that there will be a consistent bid for U.S. debt.

Although there is a strong bid for Treasuries now, that demand may wane as inflation nudges higher and global investors begin to demand more yield amid the rising federal budget deficit. We do not believe legislators or global investors fully appreciate the long-term risk of the rising deficit to domestic rates and the value of the U.S. dollar, adding complexity to the policy outlook.

The Fed’s Role

In a perfect world, a transition of leadership from monetary policy to fiscal policy as the leading global economic catalyst would have gone smoothly. In the real world, a variety of challenges have surfaced, resulting in further reliance on accommodative global central bankers rather than feuding fiscal legislators.

Even in the United States, monetary policy is still part of the story. The Fed raised interest rates four times in 2018. In retrospect, three hikes probably would have been sufficient, given the market’s poor reaction to the fourth hike in December. Lesson learned: The Fed indicated earlier this year that rate hikes would likely remain on hold for the rest of 2019. Not surprisingly, investors in risk assets rejoiced at the Fed’s decision.

With inflation low and the yield curve indicating monetary policy may be too tight for the current environment, the Fed may go further and choose to lower rates later in the year to provide a buffer against rising risks from trade and geopolitical uncertainty, even if not fully merited by the data. Such a cut would be similar to mid-cycle “insurance” cuts in 1995 and 1998, which also occurred against solid growth backdrops. For now, the Fed remains data dependent and would probably need to see additional signs of economic weakness before making a move.

Though policy decisions can be confusing, they remain central to our economic and market outlooks. We continue to believe that economic (and political) self-interest will bring the United States and China back to the negotiating table. Until we see progress, though, trade uncertainty is the primary risk to all our forecasts.

Conclusion

Even though the economic environment has become more challenging, the pillars of fundamental investing—policy, economy, fixed income, and equities—still appear sound to us. We will continue to monitor the impact of Policy – specifically trade developments on the indicators we watch. For now, the odds of a near term recession appear to remain low. U.S. stocks may endure periodic volatility as the bull market ages, but we encourage investors to focus on long term trends instead of short-term noise.