Covenant Weekly Market Synopsis for March 23, 2018

March 26, 2018

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.

For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.

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).

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$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.

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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.

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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.

Be well,

Jp.