Rate Outlook = Growth + Trade Deal – Low Inflation


lobal bond markets have largely shrugged off recent evidence of accelerating economic growth, despite much stronger than expected GDP data, blowout payroll gains and the lowest unemployment rate seen since the 1960s. Although up slightly from recent lows, yields on the US 10-year treasury over the past 6 months have declined from a peak of about 3.25% to 2.53%. We believe that if the US and China reach a trade agreement in the next few weeks, as is widely expected, then the good times for bond investors could soon come to an end.

Removing the risk of a catastrophic trade war between the two largest economies should reduce the risk premium currently built into bond prices. Reduced global uncertainty could add impetus to the already improving global growth outlook. Sizable Chinese purchases of US goods and services are likely to be a part of any trade settlement, and the impact on US growth prospects should make the Federal Reserve even more reluctant to lower interest rates anytime soon. These bond bearish developments could push 10-year interest rates back toward 3.0%.

Where is the inflation?

Although rates are likely to rise, in our opinion, we believe a very subdued rate of inflation will keep 10-year treasury rates below 3.0%. Federal Reserve Chairman Jerome Powell described the forces constraining inflation as “transitory”, but we believe the work done by Ernie Tedeschi at Evercore ISI suggests that more structural forces may be at work.

Generational lows in the unemployment rate would normally indicate building inflationary pressures. However, the headline unemployment rate excludes from the workforce any working age individuals who are not actively looking for work. Tedeschi’s analysis, shown on the chart below, indicates that the number of these prime-age non-workers (non-workers aged 25 to 54) is a better measure of inflationary wage pressures than the unemployment rate itself.

By historical standards, a substantial percentage of US prime-age workers, especially male prime-age workers, are currently not participating in the workforce. Anecdotal evidence suggests that these potential workers may face barriers to re-entering the workforce (skills mismatch, caregiver for disabled relative, history of incarceration, etc.) and may require a sustained period of very low unemployment before they can be pulled into the workforce.

These idle prime-age workers represent slack in the economy and reduced growth because these potential workers are not contributing measurable output for the overall economy.

Reduced workforce participation by prime-age workers adds to the demographically driven drop in workforce participation due to the baby boomer retirement. These combined disinflationary forces suggest that the economy may need to run “hotter for longer” before inflationary pressures emerge.

April data showed another decline in labor market participation and a surge in productivity among employed workers. Falling labor market participation and increased productivity mean that subdued labor cost pressures could continue to depress overall inflation despite the drop in the unemployment rate.

Conclusion: Portfolio Strategy

US equity markets are breaking out to all time highs, apparently confident that trade disputes will be resolved, the global economy will get back to a “synchronized upswing”, and interest rates will remain close to current levels. We do not believe that investors will receive this “best of all possible worlds” outcome. Specifically, we believe that resolution of the US/China trade dispute and continued fiscal stimulus from both of these economies will allow growth to improve. However, the after effects of President Trump’s trade wars and continued Brexit uncertainty will preclude the exuberant global growth experienced briefly in 2017 and early 2018.

Rates in the US are likely to rise as investors abandon hope of eminent interest rate reductions by the Federal Reserve and could return to about 3.0% on the 10-year treasury. Equity markets will likely experience a relief rally should a trade deal be announced, but we believe that slower earnings growth and higher interest rates will limit the ultimate gains experienced by US equity markets.

In this environment, we continue to like the strategies recommended in last month’s Strategic Insights:

  • Barbell the bond portfolio (cash and 30-year treasuries)
  • Swap US equities for high yield ($2 of high yield for every $1 in equities)
  • Underweight emerging markets to fund an overweight to Japan
  • Buy currency hedged European exporters

One modification to these recommendations is contingent upon a US/China trade deal being announced in the coming weeks. Failure of these trade talks is the biggest risk facing financial markets, in our opinion. We do not think President Trump will risk his re-election prospects by allowing current negotiations to fail, but his reputation for unpredictability suggests keeping long treasury exposure as a hedge against such an outcome. Assuming a trade deal is reached, then we would recommend moving to a short duration position by selling about 1/4th of the 30-year bond position. Rates are likely to move higher upon the announcement of a trade deal, but market reaction to much stronger than expected economic data suggests that bulls are firmly in control of the bond market. Investors may have a short window of opportunity to reposition before rates fully reflect the much lower risk environment that a trade deal should foster.

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