Economic and market perspective
Following the passage of tax reform in the fourth quarter, which has provided an economic tailwind, in March, fears of protectionism surfaced as President Trump announced tariffs on steel and aluminum. While the tariffs themselves impact a relatively small segment of global trade, they raised the specter of additional restrictions on free trade. The tariffs were raised as a trade issue at the World Trade Organization, where they were roundly criticized by the European Union, Japan and China among others. After the significant international pushback, the tariffs were narrowed, with many countries receiving exemptions. Of note, China did not receive the exemptions. In response, China implemented tariff countermeasures, prompting fears of a trade war.
Gary Cohn, President Trump’s National Economic Council Director, resigned shortly after the announcement of the tariffs, which he opposed. Additional changes among the president’s senior advisors, including replacing the Secretary of State, Rex Tillerson, amidst tensions with Iran and North Korea, increased the market’s perception of political uncertainty. The President’s new nominees for Secretary of State, Mike Pompeo, and National Security Adviser, John Bolton, are considered more hawkish than their predecessors. At the same time, North Korea invited the United States to meet, which President Trump has accepted. In parallel, the U.S. announced a renegotiated bilateral trade agreement with South Korea as talks with the North are approaching.
During March, Bank of Japan (BOJ) Governor Haruhiko Kuroda made comments suggesting that the BOJ could begin some degree of normalization next year. The possible shift is significant as many of the major central banks such as the Fed and Bank of England (BOE) have already raised rates, while the European Central Bank’s (ECB) bond buying program is set to expire in September of this year. The ECB’s staff projections show purchases being wound down over the remaining three months of the year; the Governing Council removed language indicating it would be willing to increase monthly bond purchases if needed, both are being interpreted as additional signs of coming normalization. Markets project the first rate hike from the ECB in mid-2019.
The March 20-21 meeting of Federal Open Market Committee was closely watched as Jerome Powell’s first as the new Chairman, with expectations of a 25 basis points increase in the Fed Funds rate priced in by markets. As expected, the Fed delivered a 25 basis point hike, the sixth hike of the current cycle, bringing the Fed Funds rate to a range of 1.5-1.75%. The ‘dot plot’ projections showed an increase in the median projection of the Fed Funds rate for each of the next three years as well as the long-run forecast increasing by 0.1% to 2.9%. Similarly, median GDP projections increased by 0.2% to 2.7% in 2018 and by 0.3% to 2.4% in 2019, however, inflation views remained more subdued at 1.9%. The new Fed Chairman, Jerome Powell, emphasized that these projections do not represent a singular Fed view, but the aggregation of individual members. The market is not projecting a rate hike at the Fed’s May meeting, but projecting approximately a 75% probability of a hike at the June meeting.
Outlook and conclusions
In our view, after the hot start to the year in terms of economic data, data in March returned to a positive, but more realistic trend. More moderate wage and inflation data along with increased political uncertainty led to interest rates declining, while the prospects of a trade war and increased volatility led to wider spreads for non-governmental sectors. We view fears of a tariff-driven trade war as overwrought, but the concerns have served as a healthy reminder to markets to price in risk even with a strong economic backdrop. The moderate widening offers higher yields for those sectors and provides greater cushion for investors, while fundamental economic data remains solid. The Fed’s rate hike was fully expected and priced in, thus having a limited impact on the market, while other central banks seem to be leaning, albeit slowly, towards normalization. Nonetheless, monetary policy both in the U.S. and globally remains accommodative, supporting fixed income as a sector, and with broad market fixed income yields above 3%, the highest level in almost eight years, the asset class offers opportunity for investors.