Strong US Growth, Cautious Yield Curve, Healthcare Policy Concerns
By Paul Hoffmeister, Chief Economist
· At the end of December, the predominant concerns among investors appeared to be an excessively hawkish Fed and worsening US-China trade relations. Now, the outlooks for both seem to have completely shifted for the better.
· Of the uncertainties that need to get sorted out in coming months, our two biggest concerns today relate to Brexit, which includes the EU parliamentary elections, as well as the slowdown in the major economies outside the United States.
· The results of the EU parliamentary elections in late May could be market moving; perhaps not so much because of their implications for future policy developments inside the EU Parliament but for their clues about the UK’s views going forward regarding Brexit and a forthcoming general election.
· We believe that the cautionary signals implied by the flat Treasury curve today could very well be saying that the principal macroeconomic risks reside outside the United States. And if an economic “crackup” were to occur during the next 1-2 years, it’s most likely to originate from and be most severe in foreign countries, and cause some knock-on effects to radiate back to the United States.
· Similar to 2010 with the dawn of the Affordable Care Act, we believe the major reason for this year’s selloff in the healthcare sector is uncertainty surrounding future healthcare policy, particularly because the popularity of “Medicare for All” within Democratic circles appears to be growing. But fears of an imminent demise of many of today’s healthcare companies is probably an overreaction, and the path to Medicare for All is long and windy and by no means easy.
What a difference four months make. At the end of December, the predominant concerns among investors appeared to be an excessively hawkish Fed and worsening US-China trade relations. Now, the outlooks for both seem to have completely shifted for the better.
The Fed is on pause for “some time”, according to Chairman Powell.[i] Markets believe it and are even hopeful about a rate cut. Based on interest rate futures trading on April 26, the CME Group calculated a 63.8% probability of a rate cut by year-end, 36.2% probability of no change, and no chance of a rate increase.
And in the latest sign of an imminent trade deal, President Trump said that Xi Jinping will be visiting the White House soon.[ii] This is consistent with the latest reports of significant concessions from China. In Xi’s speech at the recent Belt and Road Forum, he pledged to make a host of reforms, including changes to state subsidy policies, protecting intellectual property rights, allowing more foreign investment, and avoiding competitive devaluations – each of which are key American demands.[iii]
With the dark clouds of December having parted, the sun is now shining on markets and, in terms of macro risks, there don’t seem to be many clouds in the sky. So it makes sense that most stock markets around the world have rallied strongly year-to-date, with the S&P 500 breaking new highs. US corporate credit spreads have also tightened in recent months. Clearly, it’s been a “risk on” market environment.
Ironically, however, the current environment seems trickier today than it did in late December when many investors were panicking. At that time, there was so much worry and such a collapse in risk asset prices that the risk-reward profile of the equity market, for example, appeared to be significantly skewed in favor of being aggressively long. Today, the risk-reward dynamic seems, however, to be much more balanced.
Nonetheless, despite the appearance of less risk and less concern being priced into markets at the moment, stocks could easily continue to rise as long as no major surprises pop up. But in our view, the speed and ascent of stock prices year-to-date should slow. Most likely, the current stock market rally will shift gears from the quick, strong rebound price action to a slower “melt up”.
Of the uncertainties that need to get sorted out in coming months, our two biggest concerns relate to Brexit, which includes the EU parliamentary elections, as well as the slowdown in the major economies outside the United States.
Brexit Uncertainty Persists: Watch EU Parliamentary Elections
Based on our assessment of market behavior in recent months, the postponement of Brexit and the growing possibility of it being tabled has been a market positive – even though we believe Brexit could be endured by markets and the global economy if British policymakers swiftly combined it with new strong, pro-growth policies, such as big tax cuts on capital investment and major trade deals including with the United States. President Trump was indeed dangling that possibility in March when he said, “I’d like that whole situation with Brexit to work out. We can do a very big trade deal with the UK.”[iv]
As it stands today, Britain and the EU have a new Brexit deadline: October 31. Unless an arrangement between the UK and EU can be passed through the UK Parliament, this is just kicking the can down the road where, come October, markets could be faced again with the possibility of a no-deal Brexit.
Theresa May and her conservative counterparts have reportedly sought to make a deal with the opposition Labour Party in order to design a Brexit package that could pass Parliament. But so far, they’ve been unsuccessful.
It also appears that the Prime Minister is desperate to reach a compromise with the Labour Party to avoid the UK from having to participate in the EU parliamentary elections between May 23-26, which could result in major victories for Nigel Farage’s new no-deal Brexit Party as well as a historic rebuke of May’s Conservatives.
The results of these elections in late May could be market moving; perhaps not so much because of their implications for future policy developments inside the EU Parliament but for their clues about the UK’s views going forward regarding Brexit and a forthcoming general election.
Would a resounding victory by the Brexit Party in May’s EU parliamentary elections make Brexit inevitable? It’s possible that a big win by the Brexit Party could force the UK Parliament, the majority of which has so far refused to allow a no deal Brexit, to ultimately concede.
The Flat Treasury Curve: A Cautionary Signal
A popular question we’re hearing these days is, “Are you worried about the yield curve?” We’re not overly concerned just yet, but the flat (and in some segments inverted) Treasury curve is a cautionary signal.
Indeed, an inverted yield curve has preceded each recession during the last half century. When the yield curve flattens/inverts, the probability of recession generally rises. According to the New York Federal Reserve, between January 2018 and March 2019, the spread between the 10-year Treasury and 3-month T-bill has narrowed from 115 to only 12 basis points, increasing the probability of recession during the next 12 month s from 4% to 27%.
The good news is, however, that the US economy continues to show strength. The Bureau of Economic Analysis reported last week that real GDP grew 3.2% in Q1. At the same time, US manufacturing and job conditions appear healthy, suggesting to us that a substantial slowdown is not yet looming.
But when looking at economic growth globally, specifically the next four largest economies, there is an obvious slowdown occurring. According to the National Bureau of Statistics of China, the Chinese economy slowed from an annual growth rate of 6.8% in 2018 to 6.4% more recently. But these statistics are considered by some to be inaccurate and inflated. As for Japan, Germany and the UK, their GDP meaningfully turned lower last year; respectively slowing from 2.4%, 2.8% and 1.6% in Q4 2017 to 0.3%, 0.6% and 1.4% in Q4 2018.[v]
Quite clearly, based on the GDP data, the US economy is the healthiest economy in the world today. The US is growing while the next four largest economies are slowing.
The key differentiating macro features of the United States, in our view, are the corporate tax cuts and deregulation of 2017-2018, whereas China appears to have been struggling with changing trade rules and supply chains, and the major European countries have been enduring the uncertainties of Brexit.
As a result, we believe that the cautionary signals implied by the flat Treasury curve today could very well be saying that the principal macroeconomic risks reside outside the United States. And if an economic “crackup” were to occur during the next 1-2 years, it’s most likely to originate from and be most severe in foreign countries, and cause some knock-on effects to radiate back to the United States.
Looking at the year ahead, no economic path or consequence is set in stone. But within this slowing and more vulnerable global economy, we especially do not want to see new, anti-growth policies emerge in the major foreign economies. And just as importantly, we believe that a stronger dollar from here could be especially harmful to foreign economic actors because it would increase the real burden of dollar-denominated debts, which would be occurring within the context of a slower growth, higher interest rate world.
Healthcare: Long Way from Policy Doom for Private Healthcare Companies?
According to the Wall Street Journal, the S&P healthcare sector had fallen by 0.9% through April 17th, whereas the S&P 500 had risen nearly 16%.[vi] This is a historic underperformance. As the Journal reported, the largest deficit for healthcare stocks previously through April was 7.6 percentage points in 2010.[vii]
Similar to 2010 with the dawn of the Affordable Care Act, we believe the major reason for this year’s selloff is uncertainty surrounding future healthcare policy, particularly because the popularity of “Medicare for All” within Democratic circles appears to be growing. Bernie Sanders, for example, has made the idea a signature issue. One concern is that this version of universal healthcare could threaten or even wreck the business models of many private healthcare companies today. Almost certainly, with Joe Biden entering the race for the Democratic presidential nomination, investors will be listening closely for his views. So far, the perceived Democratic front-runner has been relatively vague about the subject.
But fears of an imminent demise of many of today’s healthcare companies is probably an overreaction, and the path to Medicare for All is long and windy and by no means easy. As we see it, for Medicare for All to become law, the idea must at the very least become a part of the Democratic platform in 2020; the Democratic nominee must beat President Trump; and Democrats would need to pick up at least 3 seats in the Senate, keep the House, and win over each Democratic senator and probably each House Democrat. A lot needs to happen in the next 2-3 years.
For his part, President Trump declared last month that the Republicans “will soon be known as the party of healthcare”. In that vein, his administration is working on new healthcare policies, which could be unveiled next year. And at the same time, the President continues to signal a desire to work with Democrats on prescription drug prices. But there appears to be no indication that he’ll propose a form of universal healthcare that will cause many of today’s private healthcare companies to go extinct.
So, given the drift and attention of both parties in Washington, we expect changes to healthcare policy in the coming years. But a lot needs to happen politically for there to be a wholesale restructuring of the system as we know it today.
Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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[i] “Powell Signals Prolonged Fed Pause as Inflation Lags, Risks Loom”, by Jeanna Smialek and Matthew Boesler, March 20, 2019, Bloomberg.
[ii] “President Trump Says Xi Jinping of China Will Visit Soon, Stirring Anticipation of a Completed Trade Deal”, by Ana Swanson, April 25, 2019, New York Times.
[iii] “China’s Xi Signals Approval for Trump’s Trade War Demands”, by Sharon Chen, John Liu and James Mayger, April 26, 2019, Bloomberg.
[iv] “Trump Eyes Big Trade Pact with Britain, Says EU Deal Ongoing”, by Susan Heavey and Kylie MacLellan, March 14, 2019, Reuters.
[v] Source: St. Louis Federal Reserve
[vi] “Health-Care Stock Rout Deepens Amid Political Pressure”, by Amrith Ramkumar, April 17, 2019, Wall Street Journal.