Equity markets started the second quarter (Q2) on the back foot, with the S&P 500 falling more than 2% on the first day of the quarter on trade fears. Yet, despite the increasingly heated trade rhetoric as the quarter progressed, the US economy only appeared to go from strength to strength and the S&P 500 finished the quarter 3.43% higher, for a first half 2018 return of 2.65%.
At the same time, the Dow Jones Industrial Average rose only 0.70% in Q2, and was still down -1.81% for the year as of June 30th. This was in sharp contrast to the technology heavy Nasdaq price index, which gained a whopping 6.33% in Q2, and registered a first half return of 8.79% – reflecting the diverging fortunes of technology companies versus industrial and financial firms that make up almost 40 percent of the Dow.
Optimism on the US side did not translate abroad, as economic growth in other developed markets softened and emerging markets had to contend with the effects of rising interest rates in the US and a stronger dollar. The MSCI EAFE index (net) fell -1.24% in Q2, resulting in a first half 2018 return of -2.75%. The MSCI emerging markets index (net) fell -7.96% in Q2, sending its first half return down to -6.66%.
As we begin the second half of the year, our biggest concerns are related to trade, monetary policy, or rather its impact on the yield curve and what it tells us about the prospects for future growth, and turbulence in emerging markets.
1. Where does the trade battle go from here?
President Trump finally got his tariffs rolling on America’s major trade partners, including Canada, China and the European Union, with the hope of inducing them to the negotiating table. However, these countries called the President’s bluff and retaliated with their own tariffs. As of this writing, the administration’s trade policy has led to new tariffs and quotas on $165 billion of US trade – US tariffs on $92 billion worth of foreign goods (including $48 billion on steel/aluminum and $34 billion on Chinese goods) and retaliatory tariffs on $73 billion of american goods. The latter includes $39 billion by EU/Canada/China as retaliation against the steel and aluminum tariffs and another $34 billion by China for singling its goods out.
As we have pointed out before, if this ends here it will not impact the economy in a major way, and all we would have gotten is a trade skirmish. At the same time, the Trump administration is working outside the framework of WTO – under WTO, tariffs would be typically be imposed on the basis of dumping claims. Instead, they are using the much wider latitude offered by US trade law, with national security used as a basis for tariffs. So far America’s trading partners have not responded in kind, choosing to retaliate with measured tariffs that would lie within the scope of WTO. Their main goal at this moment appears targeted toward inflicting political pain on the Trump administration, by targeting farmers and smaller manufacturers, rather than economic pain.
The question is whether this will escalate any further, especially if the Trump administration feels like their first round of tariffs have not gotten enough teeth to bring other countries to the negotiating table. While other countries may run out of room in a game of escalating tariffs with the US (since the US imports much more than it exports), there are qualitative ways in which they can retaliate. In fact, China may already have started down this road, by making life difficult for American businesses operating there.
2. Will the yield curve invert sooner rather than later, and is the Fed throwing it out as a recession indicator?
With inflation seemingly on target and GDP growth in Q2 looking to come in above the 4 percent mark, the Federal Reserve (Fed) appears set to raise interest rates twice more in 2018 (bringing the total number of rate hikes to four for the year). However, the bond market is a tad less optimistic about future growth. Even as equities bounced back in Q2, long term treasury yields did not rise significantly – the yield on ten year US treasuries rose just 11 basis points over the quarter to 2.85, while the thirty year yield rose just 1 basis point to 2.98 over the same period. This occurred even as the yield on short-term two year bonds rose 25 basis points to 2.52, thanks to tighter policy. The long and short of this is that we saw even more yield curve flattening in Q2, despite growth expectations picking up.
Curiously, the two-year treasury yield is hovering around the 2.50-2.60 level, even though policy makers project the target rate to hit 3.38 in 2020 (it is currently between 1.75-2.00). The bond market clearly does not buy the Fed’s projections – thinking that policy will be more dovish than currently projected or that policy will have to be reversed, with the Fed lowering rates in quick order due to a softer economy (or one that is headed into, or is in a recession). While a flattening yield curve is not indicative of a recession – only an inverted one is – the question is whether the Federal reserve is getting too hawkish, too soon.
At the same time, just as the yield curve gets closer to inversion, the Federal Reserve may be discarding it as a recession indicator. Buried in minutes from the June FOMC meeting were a few interesting details. Some participants (not a consensus opinion) argued that the Fed’s massive balance sheet, as well as a decade of near-zero interest rate policy and other factors like lower long-term inflation expectations, have distorted investor expectations and artificially pushed long-term treasury yields lower. These type of factors “might temper the reliability of the slope of the yield curve as an indicator of future economic activity”. Later in June, Fed staff published a note entitled “Don’t fear the yield curve“, introducing a new recession indicator that is superior to the yield curve. Their chart (see below) shows that the new indicator accurately predicted the last five recessions better that the yield curve, i.e. when the lines go negative. While the yield curve is a “long-term spread model” (blue line in the chart), this new indicator is a “near-term forward spread model” (red line) that tracks market expectations of monetary policy in the near future. In other words, when the red line goes negative, the market believes a rate cut is on the way due to an impending recession.
As you can see, the red line is well within its recent range, and heading away from the zero mark, even as the blue line heads toward it. While we do agree that unconventional monetary policy may have distorted markets, we are well beyond that now. Also, treasury yields do contain a significant degree of market expectations for the future and it is hard to imagine these will be significantly inferior to the information content in forward rates, especially if a recession is imminent. In any case, it is probably best to combine signals from the yield curve with other economic indicators to gauge the probability of an upcoming recession.
3. Will emerging market prospects continue to dampen?
While the big story amongst emerging market (EM) countries in Q2 were Argentina and Turkey, which we note are relatively tiny markets and have idiosyncratic issues, it seemed that turmoil was spreading to other emerging markets as well. The good news is that most emerging markets are in a much better position today than a few years ago, with larger reserves and current account surpluses (or current deficits that are smaller) – though Brazil is an odd one out due to renewed political uncertainty.
The bad news is that the US dollar is rising. The trade-weighted US dollar index rose 5.6% in Q2, almost entirely reversing its fall from the beginning of 2017. The biggest driver of this is the differential growth rates between the US and the rest of the world – growth expectations for the US are rising even as it is being cut everywhere else, which was not the case in 2017. As we wrote at the beginning of the year, the falling dollar in 2017 gave EM a reprieve from tighter monetary policy in the US. A lower dollar makes it cheaper to service dollar-denominated debt – two-thirds of hard currency liabilities are denominated in dollars. This boosts purchasing power of foreign businesses, leading to even more credit growth (in offshore dollars) and higher real investment returns. So the global upswing we saw last year fed off dollar denominated credit. However, this reversed in Q2 2018. A rising dollar now puts pressure on EM countries that have to pay off dollar denominated debt.
In addition, as India’s central bank governor recently wrote, EM countries face a double whammy of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts. Unless the Fed slows plans to shrink its balance sheet, dollar liquidity will be absorbed by the large quantity of treasuries coming to market. He notes that dollar funding has evaporated from sovereign debt markets and EM countries have faced a sharp reversal of capital outflows recently, sending their currencies lower and bond yields higher.
On top of this, oil prices have also spiked – rising more than 12% in Q2 (Brent) – which does not help large importers like India. The net result is that EM central banks are now under pressure to raise interest rates, at a time when they would rather not do so. This also assumes that current trade battles do not escalate much further and impact global supply chains that run through critical countries like China, Taiwan and South Korea.
So a corollary to this question is essentially, where the dollar goes from here, not to mention oil prices and US trade and monetary policy – which gets us back to the first two questions. While the US economy may seem less vulnerable to these factors, a crisis that erupts in EM can quickly find itself on US shores via the financial channel.
We continue to closely monitor the macro picture for any fundamental shifts that can have a significant adverse impact on the global economy, and lead to a sustained bear market.
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