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Inside the Market The U.S. economy is slowing abruptly. Here’s why there’s no need for investors to panic

The U.S. economy is slowing abruptly, with knock-on effects sure to be felt in Canada. How worried should investors be about this decelerating trend?

The answer, rather surprisingly, is not very. There is less of a link between economic growth and stock-market returns than most people think.

The real threats to today’s market comes from high valuations, political uncertainties and growing trade tensions. They could combine to take down the market. But slowing growth, by itself, is not a huge reason for concern, despite grim numbers published on Friday.

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The march of downbeat data was led by U.S. durable goods orders, which fell by the most in six months in April. The 2.1-per-cent decline was largely the result of problems at Boeing, which reported zero orders in April following crashes of two of its 737 Max planes. However, growth in durable orders outside the transportation sector also fell short of expectations.

“The growing signs that manufacturing is softening cannot be overlooked and it looks like second-quarter growth could be weaker than expected,” wrote Joel Naroff of Naroff Economic Advisors in Philadelphia.

Two U.S. Federal Reserve banks published estimates on Friday that suggested growth has fallen to less than half the 3.2-per-cent annualized pace recorded in the first quarter of the year. The “nowcast” of current economic conditions compiled by the New York Fed indicated expansion in the second quarter has slowed to a lacklustre 1.4-per-cent annualized pace. The GDPNow gauge from the Atlanta Fed said growth has braked to a 1.3-per-cent clip.

Slowing growth is never cause for joy, but investors shouldn’t panic. Over the past six decades, the correlation between changes in gross domestic product (GDP) and S&P 500 returns in any given year is close to zero. Sometimes, as in 2018, the market loses ground despite decent economic growth. Other times, as in 2009, stocks generate great returns despite a miserable economy.

The link between GDP growth one year and stock-market returns the following year is also negligible. The only relationship that exists – and it’s not all that strong – is between market returns one year and GDP growth the next. In short, the stock market seems to possess some limited ability to forecast where the economy is going next. However, the economy has little to say about where the market will head over the next few months.

This is true not just over the short term in the United States, but over longer periods around the world. In a 2005 paper, Jay Ritter of the University of Florida examined 16 countries, including Canada, between 1900 and 2002. He found that real stock-market returns tended to be stronger in countries with slower growth in GDP per person – a relationship that is the opposite of what most people would expect.

Admittedly, there are some important caveats here. According to Prof. Ritter’s research, what matters more for investors than long-term economic growth are valuations and unexpected slowdowns. If economic growth tapers in a market where stocks are trading at moderate valuations, returns can still be healthy. However, if a recession suddenly hits a market where stocks are trading at lofty prices, shareholders will feel the pain.

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The conundrum for investors is that it is not clear which description best fits the stock market right now. Based on historical earnings power, Wall Street looks extremely expensive. But based on current earnings, it is only somewhat pricey. The outlook for economic growth could swing wildly depending on whether the U.S. and China ratchet up their trade war or strike a deal in coming weeks.

All of that suggest this is a time for caution, but not for alarm. By all means, take this opportunity to reduce riskier bets in your portfolio. But don’t let slowing growth scare you out of the market entirely.

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