Friday’s plunge in equity prices and bond yields was a shot over the bow for the Trump administration. Ominously, the Russell 2000 Index of small-cap companies in the United States, the salient “Trump Trade” of 2017, fell by 3.6%.
The US 10-year yield fell below the three-month Treasury bill rate, which means investors want to lock in long-term yields against the possibility that the Federal Reserve will reduce short-term interest rates as the economy weakens.
I can’t remember offhand the last time that the stock market plunged two days after the Fed took an unexpectedly dovish stance. Stock markets love easy money, and that is what Fed Chair Jerome Powell promised at last Wednesday’s meeting of the Federal Open Market Committee.
Stocks rose on Thursday before reconsidering and dropping sharply on Friday. What weighs on the market is the economic weakness, with forward-looking indicators in Europe and Asia ex-China pointing sharply downward.
World trade began contracting sharply during the fourth quarter, as corporations postponed capital investment in response to the US-China tariff war. At the same time, US households tightened their belts in December, which reported the largest drop in retail sales in a decade.
Rarely in economic history has a US president done so much good and harm. America’s 2018 boom, which pushed GDP growth up to 3% after eight years of the most sluggish economic recovery in US history, was Donald Trump’s achievement.
Contrary to the usual Keynesian reading, which claims that the Trump tax cuts produced a “sugar high” of consumption, his combination of tax cuts and deregulation summoned up the animal spirits of American small business, who accounted for more than 100% of the job growth last year.
That was both the good news and the bad news. Small-business jobs are concentrated at the low end of the pay scale; large corporations failed to invest the proceeds of the largest corporate tax cut in US history. During the first quarter, corporate buybacks of stock exceeded capital expenditures for the first time since 2007. Still, the performance of small business was a triumph for Trump. That was then.
The small business hiring boom ran into a wall in February, when the US added only 20,000 jobs. The pool of labor available for low-skilled, low-wage jobs is exhausted and small businesses can’t pass on the cost of bidding for workers.
As I showed in several past reports, the US household sector is pulling back at the same time that world trade is contracting.
Low growth is virtually certain for 2019, and the probability of a 2020 recession is serious. Investors accept a yield for 10-year Treasury notes lower than that of the three-month Treasury bill only when they fear that growth will slow or reverse, and the Federal Reserve will reduce short-term rates.
That’s why an inverted yield curve is considered a recession forecaster. Of course, it is no such thing, but it is a gauge of the market’s frame of mind.
Absent an early resolution of the US-China trade war, this year may turn out ugly for markets as well as the economy, and President Trump’s most important accomplishment – the revival of economic growth – will fade just in time for the 2020 presidential election.