Policy risks are the main threat to the US economic expansion

Soon, the current US economic expansion will be the longest in history, and I am regularly asked when it will end.

We track a series of indicators in our Bull Market Monitor to assess the cyclical outlook for the economy. First, to what extent is the economy overheating, and therefore vulnerable to slowing and possibly a recession. Second, whether the cost and availability of money and credit is still loose, or if it has become restrictive, by policy choice or not.

The fundamental backdrop remains benign

Recent US labor market data has caused some concern that the expansion may be running out of steam, with job growth in May unexpectedly slowing to just 75,000. But we think this reflects tight supply preventing rapid job growth rather than weakening demand. Measures of labor demand, such as the ISM employment index and job openings, point to continued strength, consistent with an advanced stage of the recovery.

Tighter labor market supply might be a problem if it was translating into inflation, but wage growth remains moderate and price data has been surprisingly soft. The personal consumption expenditures (PCE) price index has fallen significantly below the Fed's 2% target, although some measures of inflation, such as the Dallas Fed trimmed mean PCE remain near the target. Importantly, subdued inflation has allowed the Fed to send more dovish signals, and risks that excessive monetary policy tightening will cause the cycle to end appear very low.

Our overall six- to 12-month tactical positioning continues to overweight equities, but with a regionally selective approach. We recently added an overweight to US equities versus international developed stocks.

The risks to the economy and markets stem mainly from policy:

1. US trade policy

The G20 summit at the end of the month is the next focal point in the US/China trade dispute. We think there’s very little chance of a deal at the G20, but we think the two sides will probably agree to continue talks. Our base case is that the US won’t swiftly implement tariffs on the remaining imports from China not currently subject to levies. Comments from US Secretary of Commerce Wilbur Ross last week echoed this view: the US and China may decide “it’s worth reopening” talks, but the G20 won’t be used as a forum for the sides to sign a final accord.

That said, the risk remains that talks break down and the US implements further tariffs, with negative implications for GDP growth and business investment. Tariff uncertainty is also not confined to China: US tariffs on autos and on imports from Mexico have been averted for now. But the threat could return later in the year if talks between the US and the EU/Japan on autos fail and concerns about migration re-emerge.

Given these downside risks, we also recommend countercyclical positions, including a long maturity Treasury position.

2. Fed policy

The Fed’s shift to a “patient” stance has reduced the risk that central bank tightening ends the cycle. But with the market now pricing in 100bps of rates cuts by the end of 2020, Fed policy holds risks for fixed income and equity markets.

The best scenario for markets, in the near term at least, would be for the Fed to meet expectations with a pre-emptive rate cut, which subsequently proves unnecessary as economic data remains strong. But ultimately something's got to give. Either the fixed income market will be proven wrong to assume sharp and sustained rate cuts, or equities will be shown to be wrong to assume a relatively benign economic outcome.

We believe it’s more likely that the economy remains relatively strong and we see no Fed cut in the coming months. Officials would take their time to adjust their communication before any move in policy. To prepare for the risk that the Fed proves more hawkish than the market is currently pricing, we recently opened an underweight in US government bonds versus cash.

Bottom line

The current US economic expansion will soon be the longest in history, but the fundamental backdrop remains benign. Recent soft labor market data reflect lack of supply rather than weaker demand and subdued inflation has allowed the Federal Reserve to send more dovish signals. The risks to the economy and markets stem mainly from policy. Escalating trade tensions are a risk to growth, which investors should protect against, but we think that the market is pricing in too much Fed easing.

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