The Record Expansion and the Tariff War

“That rule about having to act one’s age? I just don’t buy it.” —Dick Van Dyke

• This U.S. economic expansion has now become the longest on record, leaving many to wonder when it will end.

• Beyond age-based concerns about the expansion, many fear the pressures from rising tariffs may be the final straw to break the back of economic growth.

• The base case should remain that the expansion is not over, but that trade policy changes are slowing economic growth and increasing the risk of recession.

• Investors should maintain a neutral equity allocation, rebalancing on both strength and weakness, and follow a risk-management game plan.

• Opportunities can be found among lower-capitalization and value stocks as well as emerging Asian equity markets.

One of the longest bull markets in U.S. history has just found an important partner—the longest economic expansion in U.S. history (Exhibit 1). At just over 10 years of age, the current expansion has surpassed the record set in the 1990s, leaving investors to wonder when it and the bull market will come to an end.

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For the past two years, as we have neared and surpassed this record, fears of recession have intensified. Today, these fears are agitated by the escalating trade war that began in mid-2018 when the U.S. implemented tariffs on imported Chinese goods, and China reciprocated with retributive tariffs on U.S. goods. This tit-for-tat escalation has led to a cumulative estimated cost of 0.6 percent of U.S. gross domestic product (GDP) (Exhibit 2). But this is not all. Additional tariffs have been threatened. The total cost to U.S. GDP, should these threats come to fruition, could reach approximately 1.5 percent of GDP. This magnitude of potential impact helps explain why investors, economists and corporate executives have been worried about the trade war rhetoric.

Under-recognized, however, has been the slow implementation pace of the tariffs, which has lessened the negative effect on any one year’s economic growth by spreading the impact over a longer period of time. The first two rounds of Chinese tariffs, 25 percent on $50 billion in goods
and 10 percent on another $200 billion in goods, became effective in July and September 2018, respectively. This is important since we have recently passed the anniversary dates for these tariffs. As a result, while their impact on the overall level of economic activity (GDP) remains, their direct impact on year-over-year economic growth cannot recur. Interestingly, this has allowed room for the newer tariffs to come into play without inducing a larger cumulative effect on GDP growth.

While lower in magnitude, this ~0.4 percent impact on growth is still a noticeable headwind and has led to the fourth slowdown since the great recession (Exhibit 4). In addition to the headline impact of tariffs, corporate executives have slowed the deployment of expansionary capital for their businesses, and the associated rising U.S. dollar has been a headwind for international exports. Earnings growth for corporations has slowed materially following the robust growth period in 2018, particularly within the technology and energy sectors.

The key question remains: is this just another slowdown amidst a long, ongoing economic expansion or will it precipitate into a more significant economic recession? As we have shown in the past, equity markets tend to continue to perform reasonably well when earnings growth is light, so long as a recession is not developing. Recent readings from Glenmede’s proprietary recession risk model show a non-zero but still modest probability of recession within the next 12 months (Exhibit 5).

Digging further into our recession model (Exhibit 6), warning signs now appear where they had not at the beginning of 2018, but the magnitude and quantity still falls short of signaling significantly higher recession risk. In fact, of the excess indicators which gauge over-heated areas of the economy, only one has changed since 2018. GDP vs. Potential GDP is a measure of the level of economic activity relative to the economy’s potential based on population and productivity growth as determined by the Congressional Budget Office. Recent higher values on this measure indicate a modest stretching of the economy beyond typical levels. Similarly, among the leading/market indicators, only the yield curve has moved noticeably since 2018. An inverted yield curve—the difference between short- and long-term bond yields—has historically preceded recessions, but is likely distorted today by significant central bank purchases of longer-term bonds. As a result, the overall recession model signals the earlier-described rise in recession risk, but only to a still-low 24 percent probability.

While the expansion has been quite long, it has also been quite slow, leading to cumulative growth in real GDP at one-half the amount typically experienced during an expansion of this duration (Exhibit 7). Put another way, there may still be more runway ahead for the expansion. Such slow growth is likely the cause of the lack of accumulated excesses seen in our other observations and models. In short, the economic rubber band may be simply less stretched and less likely to snap back.

Investment Strategy Implications

In summary, an ongoing expansion should remain the base case for the foreseeable future, but the risk of recession has become more elevated now than earlier in the cycle. Investor anxiety is justifiable to some degree, and heightened volatility may continue. Investors should further understand that ongoing rising markets and falling fixed income yields should drive future returns lower. Expectations for longer-term portfolio returns should be adjusted accordingly.

While it may create some unease, investors should maintain a full or neutral equity position given that equities provide the dominant source of returns so long as the expansion continues. In particular, investors should carefully seek opportunities to invest amid the volatility. Lower-capitalization and value stocks have recently failed to keep pace with their larger market-cap and growth-oriented peers as the equity market has become highly concentrated in a handful of key names. While the relative performance of different capitalization and valuation cohorts could continue in the near
term, these stocks may have less room to fall in the case of a market contraction as well as offer longer-term upside. Additionally, equities in emerging Asia appear attractive yet again, this time knocked back by concerns about U.S.-China trade, despite the ongoing consumer growth wave
that continues in that region.

Lastly, recognizing the potential for downside risk, investors should utilize a modest level of risk control, adjusting this further if the risks of recession become more pronounced. Defensive equity strategies, for example focused on more stable stocks and businesses, can be a first step in achieving the desired risk reduction while offering the opportunity to outperform cash and bonds if the expansion continues. Further risk management steps would include reductions in equities, although such actions are not yet warranted. As always, we will remain on watch for key changes in the environment that would justify these actions.

You may also be interested in Video: The Next Frontier in the Record Long Expansion

This article is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information gathered from other sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative.