Investment Insights

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Setting the Pace:

A proactive Fed helps keep the economy on track

By Seamus Smyth/Stone Harbor

“The crashes people remember, but the drivers remember the near misses.” – Mario Andretti

After strong market returns so far in 2019, it’s easy to forget where we were at this point last year. 

In late 2018, a combination of rate hikes by the U.S. Federal Reserve, an escalating trade war and slowing global growth pushed global equity and credit markets down sharply. There was real fear that a recession was imminent. 

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That sentiment started to shift in January 2019 when Fed Chairman Jay Powell announced that the Fed would be patient, patience that eventually transformed into the ongoing policy easing. Since the “Powell Pivot,” risk assets—including equities and global credit—have risen dramatically, while interest rates have plummeted. The resulting easier financial conditions have helped to buffer the U.S. economy, as growth has gradually slowed though unemployment remains low. Europe, China and the rest of the world have likewise slowed to varying degrees, but have not slipped into recession.


The Fed’s actions highlight the continued role of central banks in helping markets navigate changing conditions. We think it’s helpful to view the Fed and other central banks as pace cars—also called “safety cars”—which set the pace and position of drivers during a car race. More importantly, pace cars can intervene mid-race if the course becomes treacherous. Much like a pace car, the fed in particular has shown a willingness to take proactive actions when necessary—leading to generally favorable conditions for risk assets.

Looking at the U.S., we believe the risk of a recession remains just a risk—a higher risk than in most of the past decade, but still just a risk for now. The Fed’s actions this year seem to have steadied the U.S. economy, partially offsetting the drag from trade tensions and fading fiscal stimulus. 

Lower mortgage rates appear to be hitting the accelerator for housing, offsetting weaker areas of the economy. Consumer spending remains decent, as low unemployment and modestly firmer wage gains provide support. Those two boosts balance out the ongoing drag from manufacturing. 

Driven by a global manufacturing slowdown and the trade war, the ISM Manufacturing Index declined to 47.8 in September. We’ll continue to closely monitor incoming data, especially jobless claims, as a deterioration in the labor market would increase our concern of a tire blowout for the U.S. economy. Overall, while the data remains mixed, the Fed’s intervention during a period of potential hazard appears to have set the U.S. economy on a more stable course.

Europe, however, has slowed to an even more anemic pace: below 1 percent for the Euro area as a whole, though the slowdown has not been equally distributed across sectors or countries. The same trade tensions hurting the U.S. manufacturing sector have hit the European manufacturing sector, particularly in Germany, where manufacturing comprises a larger share of the economy. 

Germany’s PMI reading has declined sharply, while France and Spain have fallen more modestly. Eurozone core inflation remains stuck at just over 1 percent, well below the European Cental Bank’s (ECB) target of just below 2 percent. As a result, the ECB has taken new actions, including a package with even lower policy rates, more quantitative easing (QE), tiering of reserves and renewed targeted longer-term refinancing operations (TLTROs). We expect these actions will support growth; however, with rates already this low, there has been substantial pushback. In our view, the room to apply more monetary stimulus looks limited, at least in the absence of a more severe downturn. In other words, the policy nudge from the ECB looks a bit weaker than that from the Fed.

China’s economy has also slowed, though more gradually than many had feared given higher U.S. tariffs enacted over the past two years. Determined to control the pace of the economic slowdown, Chinese policymakers implemented various policy easing measures earlier in 2019, and we see evidence these measures are having an impact. As a result, recent data has been mixed. Exports to the U.S. have been down sharply, but Chinese exports to other countries have increased. Housing in China appears stable, though new starts have declined. We’re also seeing signs that Chinese policymakers are calibrating their stimulus to recent economic performance. As the situation seems to have stabilized, China has taken its foot off the gas pedal and slowed down some of its stimulus measures, in particular in the monetary/financial area with a noticeable decline in the credit impulse in recent months.

One common theme is that we believe central banks and other policymakers still have the ability to stimulate their economies, though as we’ve discussed previously, the amount of policy space varies. We expect the Fed to act swiftly if they detect recessionary dynamics. For instance, in the case of meaningful labor market deterioration—an increase in the unemployment rate of more than one or two tenths of a percentage point—we believe the Fed would rapidly move the fed funds rate back to zero. How rapidly? Perhaps over the course of two meetings, with a potential intermeeting cut. We believe the Fed would also return to offering forward guidance, and the re-initiation of explicit QE is a real possibility. Unlike in Europe, the Fed appears quite reluctant to take rates negative, for reasons both practical and political.

Europe has less monetary policy space, but potentially more usable fiscal policy space. As in the U.S., we think it would take labor market deterioration for Germany to take decisive action, but the Germans appear more willing to take such steps than in the past. China has clearly shown its ability and willingness to react aggressively to deteriorating economic conditions, though high leverage has reduced the pace of policy intervention, and policymakers are acting more cautiously than during past slowdowns. Overall, while the track will not always be smooth, our base case remains that the policy pace cars will be successful in keeping the major economy race cars on track.

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