Tariffs and hawks… those were the stories last week. Unrelated, yet fused by timing. In a week that included a pre-scheduled meeting of the Federal Open Market Committee (FOMC), President Trump announced a second wave of tariffs, explicitly targeting Chinese imports. China responded…retaliated. Perceptions of a brewing trade war between the world’s two largest economies were the proximate cause for the poorest equity market performance in more than two years. The Federal Reserve also announced a widely anticipated 25bps rate hike, but their long-term interest rate forecasts were interpreted as hawkish by investors, fueling risk-off investor sentiment.
Domestic stocks bore the brunt of the pain as measured by the S&P 500, which fell nearly 6%. Although international developed and emerging stock market declines of 1% – 3% look meaningfully better, the results are likely artificially boosted by their respective time zones. Namely, these indices had already closed on Friday before the real selling pressure exerted itself on domestic markets late in the Friday trading session. All told, the S&P 500 is down 9.9% from its January peak and ended the week squarely on its 200-day moving average (a technical support line that, if breached, presages additional losses). As equities sold-off, safe-haven assets, including US Treasuries and gold, caught a bid. The recent trend of rising interest rates reversed as yields fell across the curve, with the most pronounced buying at the short-end (2-year bonds), resulting in a modest steepening of the yield curve for the week. The 10-year UST ended the week with a yield of 2.81%, after reaching into the 2.90% range early in the week. Gold rose 2.5% in response to the turmoil, as investors sought a safe port in the storm.
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Tit-for-Tat Tariffs: President Trump announced tariffs on $60 billion of Chinese products imported by the U.S. In response, China announced retaliatory tariffs on $3 billion of U.S. exports. The top chart below highlights the sectors impacted by U.S.-announced tariffs (i.e., Chinese products imported to the U.S.) while the second chart shows the U.S. exports affected by China’s tariffs (Source: Capital Economics).
$60 billion is a large number to be sure, but it is a drop in the bucket when considering the U.S. economy produces output valued at nearly $19 trillion annually. Most economists ascribe little GDP impact from the current trade restrictions announced by the U.S. and China. The more prominent risk (and the reason investors are on edge) is that these moves merely represent the first of several rounds of forthcoming tariffs. Another threat is less direct, a derivative, but just as impactful, namely, that the tariffs reduce business confidence (which is currently at an all-time high).
Are President Trump and China’s President Jinping prepared for the fallout of a full-blown trade war? It would result in mutually assured economic destruction serving neither country (there are ample examples throughout history, including the notorious Smoot-Hawley Act of 1930 blamed for exacerbating the Great Depression). Going out on a limb here a little bit, thus far the U.S. and China appear to be jockeying for advantageous negotiating positions from whence a compromise will be struck. In any event, the tariffs do not go into effect for at least 45 days, which is an eternity given how quickly things can change. For example, last week Thursday, President Trump amended his previously announced tariffs on steel and aluminum to exclude Argentina, Australia, Brazil, South Korea, Canada, Mexico, and the European Union). This view could be mistaken. And if Trump and Chinese President Jinping don’t tone down their rhetoric or choose to pursue an escalating tariff tit-for-tat, risk assets will suffer further.
Beyond the Dots: The FOMC (aka the “Fed”) announced a 25bps rate hike on Wednesday such that Federal Reserve Target Rate is now 1.5% – 1.75%. As part of this meeting, the Fed released their Summary of Economic Projections, which includes their forecast for the future path of interest rates (aka the “dot-plot”). The rate hike was anticipated, but investors took issue with a modest increase in the forecast rate path. Specifically, there is now an equal number of FOMC members looking for four rate hikes this year vs. three rate hikes. Moreover, forecasts for interest rates in 2019 and 2020 signal the possibility of slightly faster tightening.
In contrast to the dot plot, the accompanying FOMC statement was somewhat dovish. Indeed, in his press conference, new Fed Chair Powell emphasized that the FOMC is taking a day-by-day approach to monetary policy, asserting that the Fed decided on just one thing during the meeting: to raise Fed funds rate by 25bps. As FTN Financial points out, a closer examination of the dots bears this out as the divergence between hawks and doves on the committee widened. Ultimately, Chairman Powell’s press conference seemed to assuage investors. But clearly, members of the FOMC are struggling to understand how the economy will react to many factors, including Tax Reform, an expanding economy already experiencing ultra-low unemployment, the potential for fiscal stimulus, and the unwinding of the Fed’s massive balance sheet. Given the backdrop, Powell’s one-hike-at-a-time counsel seems prudent.
Another Weak Q1?: After an initial Q1 GDP growth forecast of more than 4% (which always seemed too high), the Atlanta Fed’s GDPNow estimate of Q1 GDP now reflects an annualized, real growth rate of 1.8%. Since the Financial Crisis, first quarter growth has been a seasonally slow period, followed by stronger growth later in the year.
We suspect this pattern will repeat in 2018 (with the usual caveat of barring an exogenous geopolitical or natural disaster event — to which must now be added — absent a trade war). Our full-year estimate for GDP growth remains at 2.5% – 3% range, far south of the Trump Administration’s hoped-for level of 4%, but ahead of the 2.1% average annual growth rate experienced since the Great Recession officially ended in June 2009.
A combination of reduced geopolitical tensions and economic data that was neither too cold nor too hot created a healthy environment for global risk assets. Domestic equities were the largest beneficiaries, as the S&P 500 rose 3.6% and is now only 3% below its January record level. The technology-laden Nasdaq Index rose 4.2% and hit a new high on Friday. Developed international markets (as represented by the MSCI EAFE Index) gained 1.7% while emerging and frontier market equity indices gained a little more than 1% each. As the appetite for risk increased through the week, bonds sold off, with yields on 2-, 10- and 30-year US Treasuries rising 0.02% – 0.03%. The yield on the 2-year bond ended Friday at 2.26%, while a bond that matures 28 years later offers less than 1% more in annual yield as the 30-year bond yields a scant 3.16%. Precious metals barely budged on the week, and WTI Crude gained 1.3% to $62.04 per barrel.
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Some weeks are uneventful and others…. well, others are like last week when there were a number of market-moving events. Here is a chronological summary of last week’s significant developments.
Outta’ Here: Gary Cohn resigned as President Trump’s chief economic advisor. It’s worth noting that Cohn was making more than $20,000,000 per year at Goldman, and, reportedly, received a severance package worth $285,000,000 when he left to join the administration for a $30,000 annual salary. Perhaps the conversation between President Trump and Mr. Cohn went something like this:
- Cohn: So you’re really going to impose steel and aluminum tariffs, Mr. President?
- President: Yes, I am Gary. I made a campaign promise to protect our manufacturers, and I intend to stick to it…believe me.
- Cohn: You know I’m an advocate for free markets, and these tariffs are counter to everything I believe about governments staying out of the way and allowing markets to function efficiently. With all due respect, if you go through with these tariffs Mr. President, I’m outta’ here.
- President: Well, Gary, don’t let the door hit you on the way out. By the way, even though you’re a globalist, I still like you. And I have a feeling you’ll be back.
Market Reaction: The announcement was made after the market closed on Tuesday, but S&P 500 futures fell 42 points in about 15 minutes. Shares of Goldman Sachs declined the following day by 0.6% as, apparently, investors were worried that Cohn’s departure damaged Goldman Sachs’ long-rumored influence on government policies.
Inflation? Yes please: Last week’s synopsis highlighted the change underway at the Fed with regards to inflation as one of several regime shifts reverberating through the financial markets currently.
- In a policy speech on Tuesday evening, Fed Governor Lael Brainard clarified Fed Chair Jerome Powell’s congressional testimony from the prior week.
- In sum, Brainard suggested that changing the Fed’s planned gradual pace of rate hikes even as economic headwinds have swung around to become tailwinds remains prudent. The Fed’s current view is that stronger economic growth will push the inflation path closer to their target 2% inflation rate, which has thus far remained elusive.
- Brainard also made it clear that the inflation target is symmetric, meaning that the Fed will tolerate inflation in excess of 2% since it has remained below 2% for so long. Brainard’s comments are another public indication of the Fed’s shift from inflation-targeting to price-level targeting.
- The Fed is willing to tolerate higher inflation because they are hoping to reverse the trend of declining long-term inflation expectations. Lower long-term inflation expectations keep real interest rates low and, effectively, handcuffs the Fed’s ability to counteract slower growth in recessions using only traditional monetary policy measures (i.e., cutting interest rates as opposed to engaging in another round of QE).
Market Reaction: This one’s tough to discern. Although it was an important speech regarding future monetary policy, it’s difficult to determine if investors picked-up on it immediately.
Tinder: Kim Jong-un “swiped right” and extended an invitation to President Trump to meet and discuss North Korea’s nuclear weapons program. There is some speculation that China had a hand in getting Jong-un to come to the table, but it was South Korean President Moon Jae-In who made the announcement. Relations between the two Koreas have warmed of late, including their joint participation in the recent Olympic games in South Korea. The timing, location, and specific details have yet to be worked out, and there will no doubt be controversy ahead of this meeting. But, agreeing to direct talks is a significant shift from a couple of months ago when the two leaders were comparing the size of their nuclear buttons and trading insults (President Trump nicknamed Jong-un “Rocket Man” and Jong-un responded by calling Trump a “mentally deranged U.S. dotard”).
Market Reaction: The KOSPI Index (South Korea’s main stock index) jumped 1.1% on the potential for reduced tensions between North Korea and the U.S. The invitation to speak about denuclearization also helped boost the global risk-taking appetite on Friday (even before the release of the February employment report, described below).
Goldilocks: The February employment report delivered precisely what bullish investors wanted.
- Nonfarm payrolls rose by 313,000 (vs. expectations of 200,000 new jobs). It was the strongest payroll report since July 2016, when 325,000 new jobs were added.
- Yet, the strong job growth did not engender wage inflation, as many feared. Average hourly wages rose just 0.1%, reducing the year-on-year rate of wage inflation from 2.9% to 2.6%.
- The unemployment rate remained at 4.1%, for the fifth consecutive month.
- The labor participation rate increased from 62.7% in January to 63.0% in February, counteracting the strong job growth to keep wage inflation low and the unemployment rate stable. According to the household employment survey, the labor force expanded by 806,000 and employment rose by 785,000. In other words, the surge in new hires drew in an almost equal number of people who were previously not considered part of the labor force.
Market Reaction: The employment report smashed concerns about the departure of Garry Cohn, potential trade wars and a misperception of a more hawkish Fed. Equity markets rallied, with the S&P 500 rising 1.74% to close out a strong week. If ever there was a “Goldilocks” employment report, this was it.
Equities suffered a one-two punch from the Fed and the President last week, leading to a 2% decline in the S&P 500. New Fed Chair Jerome Powell landed the first blow on the stock market during his testimony to Congress, when he testified that inflation over the long run should include times when it is below 2% and above 2% (more on this below). Fearing higher inflation, investors reacted negatively by selling stocks and the S&P 500 declined 1.6% from its intraday highs on Tuesday. The second blow landed on Thursday when President Trump announced import tariffs steel (25%) and aluminum (10%), protecting the 200,000 steel and aluminum manufacturing jobs in the U.S., but exposing the 6.5 million estimated jobs in industries that purchase steel/aluminum (e.g., auto and construction industries). The S&P declined 1.3% in response. Global equities declined as well last week: Japan’s Nikkei Index -4.4%, international developed markets (EAFE Index) -2.0%, Europe (BE500 Index) -3.5% and, emerging markets (MXEF Index) -2.8%.
Although equities took it on the chin, U.S. Treasury prices were relatively stable. The short-end of the Treasury curve barely budged (2-year yield at 2.24%), while the longer-end of the curve declined by 0.02% (30-year yield 3.14%). Evidently, the market believes the Fed will be able to effectively navigate potential inflationary pressures from economic growth or an escalating international skirmish on trade. Precious metals fell modestly (gold -0.4%, silver -0.1%) and, after rising the previous two weeks, WTI Crude declined -3.6% to $61.25 per barrel.
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In ecology, regime shifts are large, persistent changes in the structure and function of a system (Biggs, R. et al. (2009)). Regime shifts typically occur when an internal process or an external shock triggers a different system behavior. The changes tend to be non-linear and can substantially affect the flow of ecosystem services, such as the natural pollination of crops and other plants. Regime shifts occur in financial and social ecosystems as well and these significant changes from the “status quo” have the potential to influence economic conditions and financial markets. While often thought of as instantaneous change, regime shifts need not be so. Indeed, change typically begins on the margin, but it is the persistence of that change that alters prevailing trends. Only in hindsight is the point of regime change apparent. Below are five observations of current departures from the status quo representing potential regime shifts. The persistence of each of the changes will ultimately determine its impact on the economy, financial markets and how to position an investment portfolio for success.
Regime Shift Candidate I: The QE Era Is Over – In September 2017, the Fed announced they would begin to shrink the Federal Reserve’s balance sheet, ending ten years of emergency-level monetary stimulus. The Fed’s plan called for reducing their reinvestment of interest and principal payments on Treasuries and mortgage-backed securities by $10 billion per month. Every three months the amount that is held back from reinvestment will increase by $10 billion until the amount held back from reinvestment on a monthly basis maxes out at $50. The balance sheet roll-off began in October 2017 at $10B per month and is currently scheduled to be approximately $20B per month. So how is balance sheet reduction program performing? According to data from the St. Louis Fed, total assets held by the Federal Reserve have declined by approximately $62 billion over the last five months. Given they are 2/3 of the way through the second quarter of the roll-off plan, roughly $70 billion should have been withdrawn by this point ($10 million per month x 3 months + $20 million per month x 2 months). The Fed is a little off their projected pace, but not terribly so. This is especially true, as the roll-off is subject to the timing of interest payments and bonds maturing which do not necessarily coincide with the specified monthly reduction levels.
Source: Board of Governors of the Federal Reserve System and Covenant Investment Research
Importantly, the other two significant sources of Quantitative Easing (the ECB and the BOJ) have signaled monetary policy changes as well. The European Central Bank cut its Quantitative Easing program by 50% at the beginning of the year. By July of this year, the combination of balance sheet reductions by the Fed and reduced bond purchases from the ECB is forecast to result in a net withdrawal of global liquidity for the first time since QE began nearly ten years ago. Last, but not least, the Bank of Japan announced this past Friday that it would likely start exiting its massive monetary stimulus plan in early 2019, thus completing the trifecta of Quantitative Tightening.
Regime Shift Candidate II: Higher Interest Rates – At the same time the Fed is reducing the size of its balance sheet, it is also tightening another monetary policy valve by raising interest rates (for the first time in nearly ten years). DoubleLine’s Jeff Gundlach has referred to the combination of reversing Quantitative Easing and higher rates as a “Double-Barreled” approach to a more restrictive monetary regime. The current Fed forecast is to raise rates thrice in 2018, but odds are increasing that they may hike rates four times as a result of the recent tax reform policy and potential infrastructure spending plan. Below is the Federal Reserve’s latest interest rate forecast, which still indicates three rate hikes in 2018, two rate hikes in 2019 and two rate hikes in 2020, before settling into a median estimate of 2.75% (or 0.4% below the forecast peak level of 3.125% in 2020).
Source: Federal Reserve and Covenant Investment Research
Regime Shift Candidate III: New Federal Reserve Chair – For the first time in nearly 30 years, the Federal Reserve Chair will not be an academically trained economist. Paul Volcker (1979 – 1987) was the last non-Ph.D. Fed Chair, after which a parade of Ph.D. economists followed: Alan Greenspan, Ben Bernanke, and Janet Yellen. A Ph.D. is not a requirement for the role, and Jerome Powell is no slouch. He earned a JD from Georgetown University and held several investment banking roles before joining the Federal Reserve Board of Governors in 2012. It’s also no secret that Powell’s education regarding monetary policy has come mainly from on-the-job training by the Fed staff. That’s not a deficiency, but it suggests that he will be more open to staff ideas concerning monetary policy. On that point, before Powell was appointed to the Chairman role, the FOMC staff was already advancing ideas about monetary policy changes that modify the view of what constitutes “stable prices.” I’ve written about this before here if you need a refresher, but if the Fed moves from the current inflation-targeting strategy to a price-level targeting approach, the Fed would be more tolerant of inflation rising above 2% for a period leading to potentially higher levels of inflation. As noted above, Powell is now publicly hinting at this shift.
Regime Shift Candidate IV: Populism vs. Globalization – For the last several decades the world has become increasingly integrated. Disparate economies grew intertwined through trade agreements and by corporations making significant capital investments outside their home country. The Internet has contributed mightily to globalization as has immigration, connecting and assimilating people from the far corners of the globe. Since the Financial Crisis, however, a populist backlash has gained strength. This populist movement seeks to address a perception that a privileged elite is exploiting the common people. It is, in essence, a rebellion against the “elites” and the system they control. Often this leads to increased nationalism and protectionism by populist leaders. Indeed, Bridgewater’s Populism Index (constructed by tabulating votes for populist candidates) is at its highest level since the 1930’s.
Source: Bridgewater Associates
Per Ray Dalio, founder of Bridgewater Associates (the world’s largest hedge fund with $160 billion in assets) and an outstanding thought leader, “…populism’s role in shaping economic conditions will probably be more powerful than classic monetary and fiscal policies.” If populism continues to flourish, it will lead to less cooperation between countries and the potential for an increase in the number of armed conflicts. It will also reverse, or at least slow, the global commerce trend, therein negatively impacting global economic growth. One need look no further than Britain’s decision to leave the European Union or President Trump’s decision last week to impose tariffs on aluminum and steel imports as examples of political populism.
Regime Shift Candidate V: Volatility – Is the recent rise in volatility a coincidence or the result of the regime shift candidates described above? While there is no way to explicitly tie one or more of these ongoing changes to the rise in volatility this year, after an extended period of below-average volatility (as measured by the VIX Index), volatility is demonstrably higher than it was in 2017. It is logical to assume that amid the other potential regime shifts described above, we have entered an era that will be marked by volatility that is closer to the long-term average of 20 on the VIX, than the 2017 average level of 11.
Source: Bloomberg, L.P.