By: Richard A. Anderson, CFA
Stop me if you have heard this before. Uncertainty regarding trade and monetary policy are weighing on markets and the economy. These issues have held investors hostage for a number of quarters, and just when we think a resolution is within reach, there is a new disruption that serves to further increase uncertainty. I’ll address each one of these issues individually and explore how both are impacting markets and the economy.
On August 1st, President Trump announced a new 10% tariff on $300 billion worth of goods imported from China that was set to take effect on September 1st. The list of target goods included clothes, toys, cell phones, electronics, and other retail items. President Trump noted lack of progress in reaching a trade deal and failed promises by China to buy more U.S. agricultural goods and to curb to sale of fentanyl as reasons for the fresh tariffs.
Chinese officials responded by suspending the purchase of U.S. agricultural products. In 2018, China was the fourth largest consumer of U.S. agricultural exports, trailing only Mexico, Canada, and Japan. At the same time, the Chinese allowed its currency to weaken above the level of 7 yuan per U.S. dollar for the first time since 2008. All else equal, a weaker yuan would make Chinese exports more attractive, which would help offset the tariffs imposed by the U.S. on Chinese goods.
The U.S. countered China’s retaliatory actions by officially designated China a “currency manipulator,” a response that is more symbolic than it is meaningful.
We received a short reprieve from trade war fears when the Trump administration announced it was going to delay imposing tariffs on certain Chinese electronic goods and clothing from September 1st until December 15th. The delay will allow major consumer goods to be shielded from tariffs until after the holiday shopping season.
However, the reprieve was short-lived. On August 23rd, Chinese officials announced new tariffs on $75 billion of automobiles and other U.S. goods. Not to be outdone, the U.S. responded by increasing existing tariffs on $250 billion worth of Chinese goods from 25% to 30%. In addition, the 10% tariff on $300 billion dollars of Chinese goods scheduled to commence on September 1st was increased to 15%.
By year end, the average tariff rate on U.S. imports will be 24.3% and 96.8% of U.S. imports from China will be affected by tariffs. Up until this point, the U.S. consumer has been relatively shielded from the effects of the tariffs, but that could change come December 15th. As we have highlighted in past posts, the U.S. consumer has remained resilient despite headwinds, but that could change if prices of goods and services rise in response to the tariffs.
The Chinese economy has not been as resilient. China’s economy has been slowing and the tariffs have only served to accelerate this slowdown.
While U.S. and Chinese officials are expected to meet face-to-face in early October to reconvene trade talks, prospects of a trade deal remain dim. It would behoove both parties to strike a trade deal, but they remain far apart on major issues. There is growing optimism towards a trade truce, which would stop any additional tariffs from being imposed, but there is also an increasing likelihood of a permanent tariff regime.
As was widely anticipated, the Fed delivered two rates cuts over the summer months.
Following its July meeting, the Fed lowered the federal funds target rate by 0.25%, marking the first rate cut since December 2008. Although markets were anticipating this rate cut, the explanation by Fed Chair Jerome Powell was a surprise. Powell characterized the rate cut as a “midcycle adjustment,” indicating this was not the beginning of a series of reductions and investors should not assume more are likely to follow.
On the heels of its first rate cut in more than 10 years, the Fed once again lowered the federal funds target rate by 0.25% following its September meeting. The fed funds target range now stands at 1.75% to 2.00%. The second rate cut was somewhat more controversial than the July decision because the U.S. economy has been showing signs of strength and improvement.
Fed Chair Powell remained supportive of the U.S. economy, denoting the two rate cuts were viewed more as insurance in case economic pressures lead to weaker growth rather than measures taken to prevent an oncoming recession.
The Impact of Trade and Monetary Policy
If you were looking at the U.S. economy in a vacuum, you would be excused for questioning why there is so much recession talk. Sure, the U.S. economy is slowing. That’s to be expected given we are now in the longest economic expansion in U.S. history. Yet, the fundamentals remain solid. The unemployment rate is the lowest in 50 years. Wage growth is steady. Inflation is low. The housing market is healthy. Consumer and business balance sheets are strong.
But the U.S. economy doesn’t exist in a vacuum. There are other forces at play that are helping to dictate the Fed’s action, mainly trade and a slowing global economy. The heightened trade tensions and ongoing political uncertainty in multiple countries continue to act as a drag on global trade, manufacturing activity, and business investment. For these reasons, the Fed’s hand was forced. The Fed lowered interest rates to keep the economic expansion alive and protect the U.S. from being dragged down by the slowing global economy.
Against this economic backdrop, stocks and bonds had mixed results. U.S. large cap stocks recovered most of their losses following the sell-off in early August on the back of the renewed trade tensions with China but have failed to exceed their all-time highs from July. International and U.S. small cap stocks once again lagged U.S. large cap stocks, a trend that has been prevalent since the trade wars began in early 2018.
Stocks tend to receive all the headlines, but the bond market garnered some attention this quarter. The geopolitical uncertainty around the trade wars, coupled with the Fed cutting interest rates twice, drove the U.S. 10-Year Treasury yield to levels last seen in early 2016, and the yield on U.S. 30-Year Treasuries fell below 2% for the first time ever. In times of economic uncertainty and market unrest, investors typically pour money into U.S. Treasuries for stability in a phenomenon known as a “flight to safety.” When bond prices rise, which happens when there is increased demand from investors, yields fall.
One of the indicators we monitor is the Conference Board’s Leading Economic Index (LEI). The LEI has turned negative year over year before all nine recessions since 1955. The last reading for August showed a 1.1% year over year change. Although the slowing growth in the LEI is disappointing, we remain encouraged by the labor market statistics (unemployment rate and wage growth) as well as consumer spending. Consumer spending, which accounts for slightly more than two-thirds of U.S. gross domestic product (GDP), has remained resilient despite headwinds from tariffs. Consumer confidence has remained strong as well.
While we believe the risk of a recession is higher than normal, our base case is the U.S. economy is slowing but not stalling. The issues of trade and geopolitical uncertainty present headwinds that will continue to loom large over the markets. Ultimately, the Trump administration will do everything in its power to help stave off a recession until after the November 2020 election. This could mean additional fiscal stimulus in the form of tax cuts and increased government spending designed to help boost economic growth. We believe this will allow the economic expansion and bull market to continue, even if we don’t get a trade deal in the near term.
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Richard A. Anderson is a portfolio analyst at HIGHLAND Financial Advisors, LLC based out of Wayne, NJ. HIGHLAND Financial Advisors, LLC is a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management services to help clients focus on what matters most to them.
Richard graduated from Ramapo College of New Jersey where he earned a Bachelor of Science degree in Business Administration with a concentration in Finance. Richard joined the firm in June 2013 and is responsible for assisting HIGHLAND’s Wealth Advisors in developing portfolios to help individuals, families, and institutions reach their financial goals. He is a Chartered Financial Analyst (CFA) charterholder and member of CFA Society New York. For more of Rich’s thoughts on the markets and sports, follow him on Twitter and connect with him on LinkedIn.