More Trade Turbulence
All that mattered for the markets and investors this week was the direction of trade policy. Up until Thursday night it was trade with China and the falling odds of a ‘deal’ anytime soon that captured headlines. However, on Thursday seemingly out of left field Trump tweeted his plan to slap tariffs on Mexico.
This took almost everyone by surprise.
Up until now investors thought we had a trade deal with Mexico and Canada with a new and improved NAFTA agreement. Apparently, that isn’t the case. Specifically, President Trump has announced the intent to levy a 5% tariff on all goods entering the US from Mexico effective June 10th. The tariff would then increase by 5 percentage points on July 1 and every month thereafter until reaching a maximum of 25% on October 1st. They would then stay in place until the President determines that Mexico “substantially stops the illegal inflow of aliens coming through its territory”.
The US imported $352bn in goods from Mexico in 2018 and exported $265bn. The largest categories of imports from Mexico are autos and auto parts ($93bn), computers ($27bn), routers ($10bn), and other electronics ($17bn). Some products from Mexico account for a substantial share of imports in that category, such as air conditioners (44%) and TVs (35%).
Interestingly, the bulk of imports from Mexico are intra-company transactions as you can see below. Think GM moving semi completed parts from a Mexican plant to an assembly plant in the U.S.
This new battle with Mexico is different from the trade spat with China because the administration is using tariffs to achieve a purely political goal. The battle with China is ostensibly to narrow the trade gap and make trade ‘fairer.’ This new front in the trade war is to further immigration policy. As The Economist notes:
“Earlier proposals for tariffs have come with some sort of process or consultation, with Congress or the public. This one set a ten-day deadline and appears to include neither. Mick Mulvaney, the White House chief of staff, explained that this was not a trade dispute but ‘part of an immigration problem’.”
So, in a sense we are taxing domestic corporations and consumers to further immigration policy. And the latest moves against Mexico could very well make any deal with China harder to come by. Part of the deal to get the new NAFTA agreement (the United State-Mexico-Canada Agreement) was that both Canada and Mexico would no longer be threatened with tariffs. The Economist again:
“Now (Trump) appears to have pocketed that agreement, and to have used the same threat to try squeezing out a separate batch of concessions. All this while the Trump administration attempts to force unrelated concessions from the Chinese, the European Union and the Japanese. They will surely ask: what is the point of conceding to a negotiator who does not keep his word?”
So Much for the Bond Bear
A new front in the trade war is bad for both consumers and corporate profits (especially automakers), hence lower stock prices. But the correction so far isn’t anything unusual. As of Friday’s close the S&P is down -6.6% from the high set on May 3rd. We have now seen our first 5% correction for the year. Historically, we typically see about three such sell-offs in any typical year, as you can see below.
What has been more dramatic is the fall in interest rates. In the fourth quarter last year the yield on the 10-year Treasury was over 3.2%. Today we hit 2.14%, as you can see below.
Just as impressive is the move in 2-year yields. They were close to 3% in November last year, and now are down to 1.92%.
Yields are down in part because inflation expectations are falling (chart below).
But a bigger reason is that investors have gone from thinking the Fed might hike rates this year to pricing in some significant rate cuts. As you can see below the odds of rates staying stable this year now stand at just 10%. Alternatively, there is a 90% chance of a rate cut by December. Amazingly, the odds of at least three cuts now stand at close to 25%. This is a dramatic change!!
It is important to point out that falling rates do serve as a countercyclical offset to the drag from trade. Mortgage rates pushed below 4% this week and this will provide a boost to housing.
But there is no escaping the fact that trade uncertainly will weigh on growth. Consumers will have less money to spend, business investment will dry up until the outlook becomes more certain, global trade and manufacturing will slow. GDP growth will soften in the second quarter – most pundits think it will fall in the low 1% range – but no one we follow anticipates a negative quarter.
Markets are Pressuring Policy Makers
How could this play out in the months to come? In a way we are seeing a replay of the fourth quarter of last year. As Alpine Macro notes:
“…it may take more pressure from the financial markets to force policymakers to act. In early October 2018, Fed Chairman Powell was saying that the policy rate was a “long way” from neutral. As risk assets slid on the hawkish comments, Powell’s story changed in late November to rates being “just below” neutral. With markets still under pressure, Powell’s narrative switched yet again in mid-December. The Fed’s policy rate was now seen to be at the “lower end of neutral”. The dovish pivot was complete by the March 2019 FOMC meeting where the Fed formally abandoned its forecast for any further rate hikes this year.”
Now the Fed has drawn a line in the sand that the fall in inflation is transitory. Powell has argued he doesn’t need to do anything with rates because inflation is likely to pick up in the months to come. Weaker stock prices and lower bond yields could very well force him to change his view, especially if inflation expectations (see previous chart above) continue to push lower. This means the Fed could very well talk about possible rate cuts at their next meeting (June 18th and 19th), especially if markets remain volatile between then and now.
As for fiscal policy, we should look for China to ramp up reflationary efforts. Maybe the relative resilience of Chinese and emerging market assets this week are a tip off that something is coming down the pike.
Finally, politics. The latest round in the trade wars is seeing Trump’s approval rating push towards the lows last seen during the government shutdown and the Stormy Daniels mess.
While far from scientific, there is some combination of stock market level and approval rating that could lead to a change in policy, or at least a willingness to compromise. Of course, we can’t know where this is ahead of time, but there has to be a capitulation point.
Will changes in monetary policy, fiscal policy, or the political calculus change the outlook for the better? Almost certainly. Do we need to see changes to avoid a global recession? We can probably muddle along with the status quo….but a swing towards more accommodation would take out some insurance against the recession scenario.
Have a good weekend.
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