What We Know, What We Don’t Know, What We Think

It’s not even clear that central banks themselves understand what’s going on. Lower unemployment doesn’t seem to nudge inflation higher, as it once did. Commodity prices may, but not reliably.

“Tell me what you know,” Colin Powell would tell aides through his long career as a soldier and diplomat. “Then tell me what you don’t know. And then -- based on what you really know and what you really don’t know -- tell me what you think is most likely to happen.”

It’s good advice for investors, too, as the Federal Reserve approaches a historic pivot in interest rate trajectory. We know the global economy is slowing, we don’t know if our central bank tools are sufficient to reverse the trend, but we think the next recession will be short and shallow. Much will depend on the American consumer and the Chinese government.

What we know

Economic data has been weakening steadily, including last week as the International Monetary Fund downgraded its global forecasts to 3.2% this year, based on trade tensions and lagging investment. Risks, in gloomy IMF-speak, “are mainly to the downside.” Manufacturing in Europe and China continues to contract, according to Purchasing Manager Indices, and any remaining expansion in the United States seems to be flagging, too.

We also know that prices are not rising. For all their dovishness, the world’s central banks remain woefully short of their inflation targets. The Fed’s preferred price gauge, Core Personal Consumption Expenditures, which excludes volatile food and energy prices, has wilted in the summer heat. Prices have long failed to meet central bank targets in Europe and Japan as well.

GLOBAL PURCHASING MANAGERS INDICESSource: Bloomberg and Factset as of July 26, 2019

CORE INFLATION Y/Y % CHANGESource: Bloomberg and Factset as of July 26, 2019

Finally, we know that for better or for worse, we are unlikely to get much help from fiscal policy. Last week, the United States avoided another showdown between Republicans and Democrats over the debt ceiling, committing to a more or less neutral fiscal path for the next two years (and staving off one recurring source of risk through the 2020 election). While Germany could spend more and Japan could delay tax hikes, neither is likely.

What we don’t know

We don’t really know if we have the tools to reverse these trends. Certainly on the monetary side, a couple of 25-basis point cuts in the Fed Funds rate should help ensure that financial conditions support growth. But will that really be enough to overcome lingering concerns about trade friction or slowing global demand?

We also hope that looser monetary policy will help stabilize price expectations, but how much more dovish can we really get? We already have $13-trillion of the world’s bonds trading at negative interest rates, and the main impact seems to be weak bank earnings, rather than robust lending and investment.

More worrying, it’s not even clear that central banks themselves understand what’s going on. Lower unemployment doesn’t seem to nudge inflation higher, as it once did. Commodity prices may, but not reliably. The Fed’s June conference to re-assess its entire monetary framework had the worrying tone of a doctor telling a patient their chronic condition presents an “interesting case” that requires further study.

What’s most likely to happen?

Most likely, the lower rates will help at least a little. The U.S. job market will remain strong, and the U.S. consumer will enjoy a slight boost from the chance to refinance mortgages more cheaply. Meanwhile, Washington and Beijing still look far from a significant trade deal, and neither side seems eager to escalate the fight. If further hostilities can be contained over the next year, corporations may find the gumption to advance capital spending plans they can’t put off much longer.

Beyond the American consumer, the Chinese government offers the other main source of hope. Last year’s efforts to reduce excessive credit coincided with trade pressures that led to a sharp deceleration. While initial efforts to support bank lending and a fresh round of infrastructure spending have yet to deliver durable results, Chinese authorities still have plenty of tools to support domestic demand if growth continues to slow much below the current rate of 6.2%.

What if we are wrong?

Employment data is notoriously backward-looking, and political risks remain for trade friction with China and Europe. Any of these – or simply a failure of monetary policy to work as well – could finally tip the United States into a recession after its record-long expansion.

If that happens, we know that risk assets will fall; we don’t know if they might pop a bubble we can’t currently see and trigger a panic; but we think that there’s still so much money on the sidelines that any recession or market correction should be shallow and brief.