Markets just got a wake-up call on trade that interrupted their pleasant dreams of recovery from late last year. Aggressive U.S.-China negotiations have now escalated to an outright trade war, with significant tariff levies on both sides, and more threatened. Reports of Chinese flexibility on technology transfer and intellectual property violations have given way to accusations of U.S. “blackmail,” vows to never give ground on China’s “core interests,” and greater importance placed on bilateral deals with Europe. So a U.S.-China trade agreement by the late June G20 meetings now seems impossible, with any resulting deal taking longer to reach – perhaps well into 2020 – and narrowing in scope.
Investors will therefore have to be more patient for gains in risk assets, but we expect continued outperformance from U.S. assets and the dollar. American GDP is less impacted by trade than any of the world’s top 30 economies, so prolonged (or failing) trade talks mean U.S. assets can protect on the downside. For example, global equities are down 5% since early May, with the U.S. falling less and Chinese stocks plunging twice as much in dollar terms. Trade deals, delays in tariffs, or reductions of legal sanctions will benefit countries leveraged to trade like China and emerging markets from time to time, but the overall process of improvement is now likely to be slow.
Recovery from the fourth quarter of 2018 had been enabled not by a better global economy or companies’ glowing earnings reports, but a restoration of calm over fear underwritten by central banks’ continued easy money policies. The reversal of the U.S. Federal Reserve from tightening in December to driving market expectations to at least one 2019 rate cut was remarkable for an economy now growing faster than 3% year-over-year. So remarkable, in fact, that most investment teams at our firm are skeptical that Fed cuts will even come to pass.
Low inflation was the catalyst for the Fed’s pause in rates and the sharp 0.8% fall in 10-year yields since November that enabled the risky asset recovery. Companies resumed levering their capital structures, housing improved, and investors went back to bidding up equity earnings multiples. Markets are now so skeptical that core inflation will rise above the Fed’s 2% target that improved economic growth alone cannot keep longer-dated yields from falling below those of Fed Funds. Utilities and other interest-sensitive equity sectors have therefore become overvalued, and trade-weighted dollar languished through April.
For decades, the Fed believed that wage inflation leads broad inflation, but there is little current evidence of that relationship. Nonetheless, the labor market continues to tighten and the U.S. economy is likely to outperform its potential, which is good news. A modest pickup in inflation and interest rates should eventually result, however, tempering the performance of rate-sensitive credit and emerging market assets that jumped during the Fed’s about-face.
Despite negative trade issues, the global economy is showing signs of re-accelerating, primarily because of the success of Chinese stimulus. Those early signs have to be followed by better results or non-U.S. equities will continue to lag those in the U.S. Wage and other cost increases have caused profit margins globally to decline even as revenues continue to grow. Credit – especially outside the U.S. – is more sensitive than equity to profit margins, so could underperform other risk assets if this decline is sustained. Municipal bonds, which have moved steadily higher this year thus avoiding periodic risks seen elsewhere in credit, have benefited from unusual investor demand that will be hard to sustain in the second half of the year.
This article was written by Derek Sasveld, Investment Strategist. Opinions are as of May 28, 2019 and are subject to change.