In March, we held our quarterly multi-asset meeting in Toronto. In conversations with our colleagues from BMO’s global investment organization, we found ourselves discussing at length the possibility of an overheating economy due to growth and inflation. Even just a year ago, many investors believed growth and inflation were both too tepid to provoke central banks to end stimulus. Now, overheating seems like a genuine risk and forms the basis for our downside scenario — where the Trump administration looks to change the slower-growth narrative through broad and expensive fiscal policy while imposing wider and heavier tariffs.
Financial markets finally awakened to some of this uncertainty in the first quarter. After a quiet and steady rise in January, during which markets appeared relatively unperturbed by fiscal policy, monetary policy and geopolitics, volatility roared back in February on inflation concerns, and was further stoked in March by trade fears. These fears proved powerful enough to leave most equity indexes negative for the quarter.
While some “risk-off” signals, such as inflows to gold and government bonds, appeared especially in late March, other developments positive for global growth continued to emerge even as markets got jittery.
Nonetheless, with overheating concerns now up and about, we expect some wider market swings in the near term.
What you call protectionism we call negotiation
After markets bounced back strongly from February’s inflation fears, the Trump administration jolted them again in early March with an announcement of blanket tariffs on steel and aluminum. Though the administration eventually walked back the scope of the tariffs, providing exemptions for the European Union and other key trading partners, it sent a clear message that trade strategy is next on the agenda. The exemption offered Canada and Mexico a needed respite from trade headlines, but it will likely be used as leverage in the NAFTA negotiations, where progress has been excruciatingly slow, unaided by President Trump’s admission he did not know the trade-deficit facts ahead of his meeting with Canadian Prime Minister Justin Trudeau.
The administration followed the steel and aluminum tariffs with a more aggressive tariff program for China. The Chinese appear to be the main target for the administration’s combative trade policy due to the wide bilateral trade deficit between the United States and China, alleged Chinese intellectual property theft and the country’s stringent rules around foreign company ownership. Though markets reacted to the tariff announcements, many economists view these maneuvers as part of a broader negotiation that may not lead to a full-scale trade war. However, with the political rise of China hawks Robert Lighthizer and Peter Navarro, as well as the appointment of John Bolton as national security adviser, we expect U.S.-China trade tensions to remain high for the foreseeable future.
In our discussions in Toronto, we observed that the Trump administration has thus far focused on stock prices, economic growth and wages. For all of its aggressive talk, the administration tends to back off if policy negatively impacts these three factors. In the midst of the late-March selloff, Treasury Secretary Steven Mnuchin quickly asserted that the U.S. and China were in fact negotiating, which helped placate markets. It remains to be seen whether this dynamic continues with the recent staffing changes in the White House, most notably the departure of economic adviser Gary Cohn.
Hearing the hawks
Last year, in line with downturn fears and expectations for continued low inflation, the consensus outlook for market participants implied two rate hikes in 2018 versus the Federal Reserve’s (Fed’s) “dot plot,” which anticipated three hikes. At the time, we diverged from the market’s forecast and believed the Fed would turn more hawkish this year. Markets appear to have converged on this view overall, with some recent discussion of perhaps even four rate hikes 2018, the first under Jerome Powell having arrived on schedule in March.
Thus far, Powell has been what we expected as Fed chair, but he may face stronger political challenges ahead. Larry Kudlow, President Trump’s newly appointed director of the National Economic Council, has been more aggressive in his rhetoric than his predecessor Gary Cohn, saying recently that the Fed should get out of the way and “let it [the economy] rip.” He’s also on the record stating that the Fed’s inflation measures aren’t effective and that it does not have the power to move prices, even though price stability is part of its mandate. Until now, the Trump administration has been relatively quiet on Fed action and Cohn seemed to reinforce this posture — we’ll see if Kudlow maintains this approach as he moves from media pundit to an administration role.
The European Central Bank (ECB) changed the forward guidance in its March statement by removing the language declaring its willingness to increase asset purchases. While President Mario Draghi downplayed the change, it does signal the ECB’s desire to slowly move away from its ultra-accommodative stance, given strong European growth. Though protectionism and nationalistic voices (notably in Italy) persist as a risk here, overall we see the Fed’s actions as previewing the future course for the ECB, albeit a number of years ahead. Inflation remains below expectations in the eurozone, but growth is still strong enough to expect further steps toward normalization.
The danger of deficits
Though it generates fewer headlines than stock-price swings, U.S. fiscal policy may be one way in which the world has actually changed. At the very least, we are moving into territory that is vaguely mapped and rarely visited. With many economists suggesting that the U.S. business cycle is reaching a mid-to-late stage, the Trump administration continues to deploy stimulus typically associated with earlier stages of the cycle. In fact, this level of fiscal stimulus (a $1.5 trillion tax cut and $400 billion rise in spending) at this stage of the cycle has no recent precedent and thus creates something of an unknown.
We think the U.S. expansion, approaching the longest on record, will continue, but the most salient risk from late stimulus is the old bugaboo of inflation. The downside scenario is that the stimulus spurs inflation and increases the risk of a hawkish Fed tightening monetary policy and slowing the economy. In a typical cycle, the government reigns in deficits during the good years and expands them when the economy falters, providing a counterbalance. However, if the economy slows in the coming years, the government may be reluctant or unable to expand an already large deficit, which could exacerbate the downturn.
U.S. economy: Plenty of pie but who gets a slice?
Our confidence in the U.S. economy emerges from the steady flow of good news regarding corporate earnings, which continue to beat estimates. We expect growth to continue under the 2017 tax reform, though the emphasis on share buybacks will deliver most of the profits to shareholders rather than workers. Wage growth continues to be modest despite job gains. Even with these imbalances, U.S. consumer confidence advanced in March (101.4 versus 99.7 in February) and reached its highest level since 2004, with gains coming from respondents in the bottom third of income distribution. While the Trump administration’s policies may challenge economic orthodoxy, Americans appear to be giving them the benefit of the doubt at the moment.
Political risks on a low simmer
Outside of the aforementioned trade policy, we see moderate political risk around the globe. Turning our focus to Europe, we view the ascension of the Five Star Movement in Italy as worrisome for the eurozone economy. In Germany, the political situation stabilized with the Social Democrats’ approval of a coalition with Chancellor Angela Merkel’s Christian Democrats, but Merkel has many challenges ahead after the acrimonious run-up to the coalition vote and the increased presence of the far-right Alternative for Germany.
Meanwhile, we are now merely one year away from the U.K.’s departure from the European Union with some significant questions as yet unanswered. Negotiations have, however, yielded some productive compromises, including the U.K.’s consent to a financial settlement and the agreement to extend the “transition period” until the end of 2020.
Political concerns have flared up once again in Japan, as corruption allegations against Prime Minister Shinzo Abe and his administration resurfaced. Abe has led a reawakening of the Japanese economy, which has attracted foreign and domestic investors to the once-moribund market. His potential departure has significant implications for Japanese stock prices, which are notably positive since he regained power in 2012 on the back of his “Abenomics” platform. However, even Abe’s exit would be unlikely to alter the Bank of Japan’s highly accommodative monetary policy, which we believe eases some of the political risk here.
We saw some encouraging developments on the Korean Peninsula, where tensions have lessened, at least in the near term. Bolstered by successful nuclear tests, North Korean leader Kim Jong Un has re-engaged with foreign powers, meeting first with Chinese President Xi Jinping in Beijing and scheduling an April meeting with South Korean leadership. A later meeting with President Trump has been agreed upon in principle, though the likelihood of both leaders following through on the commitment remains in doubt. Peace between North Korea and its foes, even if it is somewhat fragile at this point, would remove a significant tail risk from the market.
We made no changes to our asset allocation strategy this quarter and remain overweight equities due to solid earnings momentum and strong economic growth. Political risk remains a concern, though we see some encouraging signs in Europe and hints that negotiations between trading partners will progress rather than deteriorate into trade wars.