By Thomas Dillman
Currently, stock and bond markets in the United States and around the world are responding almost exclusively to two macroeconomic issues. One relates to trade talks between the U.S. and China, and the other involves the Fed Funds rate and what moves, if any, the U.S. Federal Reserve will make next. While the trends in economic data and corporate earnings remain important, Mutual of America Capital Management LLC explores why the trajectories and outcomes of these two macroeconomic factors will determine the path of growth and corporate profits.
Issue 1: U.S.–China Trade
In March 2018, President Trump's administration began to impose tariffs on select goods imported from China. The announced purpose was to get China to halt what the U.S. claimed were "unfair trade practices," the core of which involved the requirement that U.S. companies enter joint ventures with Chinese companies in order to gain access to Chinese markets. This requirement, according to the Trump administration, allowed China to use, copy or steal proprietary technology. Furthermore, Trump argued that the trade deficit with China of close to $400 billion was proof of the inequity of trade relations between the two countries. China retaliated almost immediately with its own tariffs on imported U.S goods. By the end of 2018, the dollar value of Chinese goods subject to U.S. tariffs exceeded $250 billion, at an average rate of about 10%. Given that the U.S. imports $500 billion worth of Chinese goods per year, while China imports only about $120 billion worth of U.S. goods, the amount of U.S. goods on which China imposed tariffs is much less.1
In December 2018, President Trump and Chinese President Xi Jinping met after the G-20 summit in Buenos Aires and agreed to halt new tariffs for 90 days and to initiate trade talks. Trump warned China that if a deal had not been worked out after the agreed period of negotiations, he would raise tariff rates on $200 billion of Chinese imports from 10% to 25%. During the next three months, there were indications that progress had been made, but a few issues remained. Trump and Xi agreed to extend the trade talks without announcing a deadline. They also agreed to meet again in the near future, ostensibly to sign a formal agreement.
Over the next two months, the tone of news coming out of the trade talks was intermittently optimistic and pessimistic. Market volatility increased, with stocks unable to maintain levels above recently attained new highs. Then, in early May, Trump announced that he was raising the tariff rate from 10% to 25% on $200 billion worth of goods. China announced it would retaliate. Robert Lighthizer, chief U.S. trade negotiator, stated at that time, "Over the last week or so, we have seen an erosion in commitments by China."2 According to multiple news sources, Chinese negotiators modified the language in the near-final version of an agreement, which effectively changed the terms to China's advantage. The explanations for why China took this course of action are varied: it was a last-minute negotiating ploy; Xi felt pressure at home to not capitulate to a deal that would handicap China's long-term "Made in China" strategy; or, the calculation that Trump's attacks on the U.S. Federal Reserve indicated the U.S. economy was weaker than it seemed. Both sides suggest that trade talks could resume in the future, but for the time being, talks are deadlocked.
If the U.S. and China fail to make a deal, which includes a reduction in tariffs, global economic growth will diminish. Estimates of the impact on the economies of both countries vary, but all are negative. The "unanticipated consequences" of interaction effects among various other economies is equally important. But there is no trade war scenario that is optimistic. The move toward greater free trade among nations over the past 25 years has been one of the most potent drivers of growth and improved relative prosperity throughout the world. A reversal in that approach can only be harmful to growth and wealth accumulation. Recession is increasingly likely if China and the U.S. do not resolve their issues. Moreover, markets will react negatively, and in all probability, severely, if they conclude that no deal will be reached.
Issue 2: Federal Reserve Rate Policy
The second macro issue affecting markets recently is the question of future Federal Reserve rate policy. The policy is always a concern of the financial markets. This market cycle has been characterized by more analytical focus on the Fed than any in the past because the Fed has used tactics never before tried to such extremes, such as quantitative easing and zero interest rates. Markets become increasingly nervous whenever the Fed is in a rate-raising cycle, as it has been over the past three years, and especially during long economic and market cycles. The current S&P 500 ® bull market is already the longest in history, and the current economic expansion is also on the verge of attaining that distinction.
A clear sign of investor concern about the rising Fed Funds rate was the late-2018 near-bear market meltdown in stock prices. Despite the early December announcement that U.S.-China trade talks would resume, markets kept declining in anticipation that the Fed would initiate another rate increase in its upcoming meeting, which it did. Even before the increase, many economists believed the Fed had gone too far, and that its actions would lead to a recession. In response to the subsequent market volatility, the Fed began to signal that it shifted to a wait-and-see stance. At its next meeting, in January 2019, it made that position official, but emphasized any future changes would be dependent on the flow of economic data.
What was becoming increasingly clear to investors in the latter part of last year was that the trend of economic data from China, Europe and the U.S. indicated economic growth was continuing to slow. Except for very strong employment data (e.g., near historic lows for the unemployment rate, still firm monthly hiring and some upward movement in wages), which implied continued demand, the economic data in the U.S. proved to have a soft underbelly upon further analysis. For instance, first-quarter Gross Domestic Product (GDP) came in well above expectations, at 3.2%, but examining the details revealed that consumer spending and capital investment both slowed, while residential housing continued only at a tepid advance. One factor accounting for the strong number reported came from an inventory buildup that likely will steal production from future quarterly GDP. The other was strong net exports driven by robust ordering by Chinese importers and weaker-than-usual orders of Chinese goods from U.S. buyers. Both of these sources of reported GDP strength were one-time events, while the key drivers of domestic demand decelerated. Excluding government spending, net exports and inventories from reported GDP, the result represents purely domestic spending, the key driver of U.S. growth. For the first quarter, this measure registered an anemic 1.3% advance.3
For investors, this was a clear sign that the Fed's next move should be a rate reduction, rather than holding at current levels, or worse, another increase. Operating under a theory that increasingly stronger employment data would cause inflation to rise, the Fed set an inflation rate of 2.0% as its target. While the Consumer Price Index (CPI) had hovered around this level for a long time, the Personal Consumption Expenditures Index (PCE) – the Fed's preferred rate – had fallen from this level and, in the first quarter, dropped from its recent average level of 1.5% to 0.5%.4 In short, the data was not confirming the theory the Fed was using as its frame of reference. The stable-to-falling inflation rate belied the theory and suggested the Fed could safely lower rates until inflation began to accelerate, if at all.
In addition, as the Fed made its last rate hike, an inverted yield curve – a traditional sign of approaching recession in which short-term rates exceed long-term rates – occurred. This raised investors' fears and fostered calls for rate reductions. Current probabilities implied within the structure of bond rates suggest a high, and rising, expectation that the Fed will lower rates sometime in the second half of 2019 on the assumption that rates remain too high, thus constraining economic activity and potentially throwing the domestic economy into recession. If either the U.S. or China shows signs of decelerating further than they already have, markets likely would respond quickly to the downside.
Note that these two macro issues skew to the negative. If the U.S. and China do not reach a substantive accord, and/or the Fed remains skeptical that rate reductions should be the next step, investors are more likely to move money into increasingly safer, so-called "haven" securities, such as U.S. Treasury bonds, customarily stable dividend stocks, and the ultimate safe haven, cash. And, if the odds of recession continue to increase, investors will begin to sell stocks aggressively.
A complicating factor in this scenario is the rise and predominance of algorithmic trading – the use of high-speed computers to almost instantaneously assess the direction of the markets – and investors' tendency to act on that information to their advantage. A flood of selling by fundamental investors, hedge funds and, ultimately, private individuals, would be enhanced dramatically by algorithmic trading. A similar event occurred in 1987 when a market panic was fueled by a product called "portfolio insurance." In that particular case, the economy was actually accelerating. Markets recovered within a few months and went on to reach new highs. In the current situation, economic data is weaker, interest rates seem too high for the economy as it is now performing, and the market is in an advanced stage of its normal development.
Coupled with the high costs of, and necessary readjustments to, a potentially failed U.S.-China agreement, as well as a possible miscalculation by the Federal Reserve, significant hurdles exist for continued, long-term advancement in both domestic and global growth. However, in our opinion, while volatility may exacerbate the markets' problems in the short term, we believe that these two issues, ultimately, will be resolved and, therefore, investors should not try to time the market based on macro events.
Thomas Dillman is the former President of Mutual of America Capital Management LLC.
|1||United Census Bureau, Foreign Trade, March 2019.|
Jen Kirby, "US-China Trade Talks End With No Deal-And More Tariffs," Vox, May 10, 2019.
Chris Low, "GDP Beats Expectations, But Not Really," FTN Financial Economics Am Comment, April 26, 2019.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.