Market Recap

Posted on July 13, 2018 by Gemmer Asset

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Inflation Heats Up – Bond Yields Go Nowhere

 

Sometimes the link between the economic data and the market reaction can leave you scratching your head. For example, this week’s inflation report was on the hot side. The Consumer Price Index (CPI) increased at an annualized rate of +2.8% in June while the core rate was up +2.0%. Both were slightly above expectations. The graph below shows four different measures of inflation, but you get the point. The lines are pointing upwards and towards the right.

 

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Earlier in the week the producer price index increased at the fastest rate in over six years, as you can see below. Energy and transportation costs contributed to the jump.

 

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So how did the bond markets react (the market most sensitive to inflation)? Of course, long-term bond yields didn’t move an inch. They closed the week where they started. Granted, 2-year yields increased fractionally, but overall the reaction was muted.

 

What’s going on? You could argue the markets are dumb. Bond investors are too busy watching the World Cup (ohhhh, the pain!!), the Tour, Wimbledon. But more likely the fixed income market is probably asking itself a version of the following: “Yea, tell me something I don’t know. But what’s going to happens 12 months from now?”

 

And on this score the fixed income market is thinking the Fed is going to keep pushing rates higher through at least the middle of 2019 – say four more hikes. This takes the Fed Funds to between 2.75% and 3.00%. At this level they are betting long-term rates start to price in a meaningful economic slowdown, after all, the yield curve is getting flat as a pancake, as you can see below. The spread between the 10-year and 2-year is down to just 24.7bps.

 

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As we’ve talked about endlessly, an inverted curve can herald a recession in the next year or two, which is naturally deflationary and leads to lower bond yields. So maybe the bond market is looking through the short-term inflationary pressures towards slower growth and possible recession in late 2019 or 2020.

 

The Trade Rhetoric is Turned Up Another Notch

 

And then there is trade.

 

Let’s review. The U.S. imposed tariffs of 25% on $34 billion of Chinese goods last Friday. Tariffs on another $16 billion are set to go in effect on July 20th. Naturally, China is set to retaliate on $50 billion of our exports. But so far, the average U.S. tariff hasn’t moved much, as you can see below.

 

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But things are getting more, shall we say, interesting, Trump upped the ante by announcing that he will levy a 10% tariff on an additional $200 billion of Chinese imports by August 31st. He also threatened tariffs on another $300 billion on top of that if China still refuses to back down (whatever that means). As Bank Credit Analyst notes:

 

“That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than what China exported to the U.S. last year!”

 

China’s options are limited. It will have to find non-tariff measures to retaliate with if the $200 billion plan goes through. They simply do not export enough to the U.S. As George Magnus notes:

 

“Some observers have expected China to devalue the Renminbi or sell some of its holdings of US Treasury bonds. These actions are ‘old chestnuts’ and most unlikely. The latter would be self-defeating because Chinese reserve asset values would drop. The former would risk reigniting capital flight at a highly sensitive time for the Chinese economy, and destabilising Asian and global markets — in which China has no interest.”

 

More likely is a move by China to target or discriminate against U.S. companies operating in China, making it more cumbersome or expensive for them to do business relative to E.U. or Japanese firms, for example. George Magus again:

 

“The government could delay or block licenses and approvals for US companies in China, and subject US investment in and imports to China to administrative delays, inspections, and general awkwardness. Further, it could simply confirm the operational management difficulties about which foreign firms complain, by insisting that state-owned enterprises and other Chinese firms continue to benefit from special regulatory and commercial treatment, and make life difficult for US firms.”

 

If Tesla thinks building that plant in China to produce 500K cars is going to be easy, they have another thing coming!!

 

Maybe the Bond Market is Pricing in a Trade War Accurately

 

Obviously, this issue isn’t going away. For better or worse, the saber rattling sells in much of the U.S. Free trade isn’t thought very highly of, as you can see below.

 

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With the mid-term rearing their ugly head in a few short months, this topic is viewed as a vote winner in select circles.

 

So how do you plug all these moving pieces into an econometric model? Ummmm, you really can’t do it very effectively, but that won’t stop anyone. Goldman Sachs and JP Morgan took a stab and think the tariffs applied to date would reduce global growth by about -0.3% and increase inflation by +0.1%. Not much really. But how about another $500 billion of tariffs?

 

How do you model the complex supply chain network that has evolved over the last 30 or 40 years? For example, a small fire at a factory in Japan that manufactured 60% of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry.

 

So here is another reason bond yields haven’t moved much and the yield curve has flattened. How do you hedge against a trade war? A decent bet is to buy bonds, after all, a full-blown trade war is probably going to lead to lower global growth and a possible recession.

 

But won’t the imposition of tariffs lead to inflation? Tim Duy addressed this point in a good article:

 

“Tariffs threaten to push inflation rates higher than expected over the next year. Should the Fed view the increase as transitory or something more sinister? On the surface, the answer should be straightforward. While tariffs should be seen as a supply-side shock that drives prices higher while pushing output lower, they should result in a level shock to prices, leaving any increase in inflation rates as transitory.”

 

Tariffs lead to a one-time adjustment in prices. The cost of the widget imported from China goes up by the amount of the tariff in year 1, but the price stays the same in year 2. Fed leaders in years past would of ignore this from a policy perspective.

 

Ultimately, the bond market is acting quite rationally despite the rising inflation numbers. Tighter Fed policy and the trajectory of trade policy go a long way towards explaining relatively stable longer-term yields and a flattening curve.

 

Have a good weekend.

 

 

Charles Email Sig

 

 

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