Market Recap

Posted on May 25, 2019 by Gemmer Asset

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Markets Buffeted by Trade


Global equity markets were down this week as jitters about the trade war with China increased. The Trump administration upped the ante last Friday by blacklisting Huawei. As a result, US chipmakers, including Intel, Qualcomm, Xilinx and Broadcom, have suspended supplying Huawei with semiconductors – a devastating blow to the Chinese telco. What’s still unclear is just how far each country will go in this war of attrition. With no end – or deal – in clear sight, the jury is out on how this story will conclude. Three things stood out to us this week that seems to indicate a long slog ahead on trade:


1) There are growing signs that the administration thinks the trade battle with China will be a vote winner next fall.


2) China also appears to be digging in for a long battle. For example, on the same day the U.S. went after Huawei, Chinese President Xi Jinping paid a rare but highly publicized visit to JL MAG Rare-Earth Company. Rare earth elements have a number of critical industrial uses and it just so happens that 80% of U.S. rare earth imports come from China. The visit fueled speculation that the strategic materials could be weaponized in China’s tit-for-tat with the U.S. on trade. It is also interesting that Xi was accompanied on the trip Liu He, the vice premier who has led the Chinese side in the trade negotiations.


3) Another sign that China is less willing to compromise came on Tuesday. President Xi and Vice Premier, He made another highly-publicized stop. This time, they visited a memorial to the “Long March,” one of communist China’s most formative events. President Xi laid a floral arrangement at the memorial and said, “We are now embarking on a new Long March, and we must start all over again.”


The next key date on the agenda is June 28th and 29th. This is when the G-20 meet in Japan and both Xi and Trump will attend. Will Trump try to come away from the meeting with some sort of deal? Or will he ratchet up the pressure?


Assuming the G20 comes and goes without a deal, there are two possible paths. One is that the two sides resume negotiations and try to resurrect an agreement before the economic and market damage of the trade frictions becomes too acute. Or do they conclude the gap is unbridgeable and the existing US tariffs become permanent, along perhaps with additional levies on the roughly US$300bn of imports from China that remain untaxed.


Manufacturing Struggles…


The chart below is worth looking at. As you can see, if the U.S. finally puts a 25% tariff on all our imports from China, this would take the effective tariff rate back to the levels last seen in the early 1960s. The $64 trillion question is what happens to global trade. Will it fall, or will production simply move somewhere else?



Economic theory argues that tariffs are simply a tax. Whatever you tax you get less off. Therefore, it stands to reason we’ll buy less Chinese goods. But will we buy less overall, or simply buy more from Cambodia, Vietnam, etc? The answer is probably somewhere between both extremes.


But China will also buy less of what we make. Even before the next round of tariffs goes into effect domestic manufacturing is feeling some pain. On Friday we found out that new orders for durable goods fell by -2.1% in April (as you can see below), reflecting a large decrease in aircraft and aircraft parts sales. Part of this is due to Boeing’s specific issues, but even stripping this out core orders were down -0.9%.



This isn’t a new story. Durable goods orders have been underwhelming for some time. But it builds the case that growth in the second quarter is likely to be soft. After Friday’s report JP Morgan cut its forecast for second quarter growth to +1% from +2.25%. Oxford Economics lowered it’s estimate to +1.3% from +1.6%. The Atlanta Fed is now at +1.3%. This would be a marked slowdown from growth in the first quarter.



…Increases the Odds of a Rate Cut


While equity prices were soft this week, government bonds performed well. U.S. Treasury yields plunged to their lowest level since 2017 and the yield on the 10-year pushed well below 2.4%, as you can see below.



10-year yields are now back to roughly the same level as when the Federal Reserve began raising rates in 2015. Certainly, there is a ‘flight-to-safety’ aspect to lower yields. But there are a couple other things at play. First, inflation expectations are low and core inflation is trending lower, as you can see below.



This week’s FOMC minutes revealed that the latest Fed staff forecast had inflation remaining below 2% over the medium term. This is in sharp contrast to Chairman Powell’s comments that the inflation undershoot is due to transitory factors. If GDP growth slows to trend or below, it will become even more likely that inflation continues to miss the Fed’s target.


Second, the odds of a Fed rate cut spiked higher this week. As you can see below, the odds of at least one rate cut by the end of this year stand at 75%.



To the extent inflation falls further, growth slows, and/or the trade situation worsens we should see these odds increase even further (if you want a provocative piece, take a look at this argument for why the Fed may not hike rates again for at least ten years).


The next Fed meeting is June 18th and 19th. We will probably start hearing from some of the Fed leaders soon if they plan to tweak policy at the upcoming meeting.


Have a good weekend.






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