Tariffs and tweets drown out the Fed           

Brian Nick

The last week’s market highlights:

Quote of the week:

“We cannot solve our problems with the same thinking we used when we created them.”
– Albert Einstein    
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s Midyear Outlook :
  • U.S. economy: Late cycle but no recession
  • Global economy: Still looking for a bottom    
  • Policy watch: Easy monetary policy to offset restrictive trade policy  
  • Fixed income: Volatile interest rates but no breakout in either direction 
  • Equities: Get defensive, stay invested 
  • Asset allocation: No longer “risk on,” but still prefer emerging-market bonds  

Global economy: Eurozone assets “yield” to the U.S.                     

Given the speed and volume of today’s news flow, events that took place just a few months ago seem like ancient history. So it’s understandable that investors may have forgotten that, back in 2011, yields on 10-year U.S. and German government bonds—considered to be among the safest investments in the world—were virtually identical. During that year, the yield on the bellwether 10-year U.S. Treasury ranged from 1.72% to 3.75%, versus 1.69% to 3.50% for its German counterpart, the 10-year bund.
But beginning in 2012, the yield gap between the two began to widen, mostly because eurozone sovereign bond yields started to collapse. Driving their decline: steady demand for safe assets, stubbornly low inflation, sluggish economic growth and aggressive bond buying by the European Central Bank designed to jumpstart the eurozone economy. In November 2018, the spread reached a record-high 279 basis points (2.79%), as the 10-year Treasury hit a 7½-year peak of 3.22% while the bund touched 0.43%.
Fast forward to this past Friday, August 23. Although the U.S. 10-year closed the week at just 1.52%—a signal that bond investors are pessimistic about the long-term U.S. economic outlook—it still provided a considerably higher payout than the 10-year bund, which finished at -0.67%. This negative yield means bunds are guaranteed to generate a loss if held to maturity.       
The widening U.S./German yield spread has been accompanied by a stronger U.S. dollar relative to the euro. That’s because capital tends to flow toward countries offering higher-yielding assets. Over the past 8+ years, the dollar has rallied from a low of $1.49 per euro in May 2011 to $1.11 on August 23, 2019.
Dollar strength has also been correlated with U.S. equity outperformance. Indeed, since January 2011, the S&P 500 Index (+12.6% average annual return) has handily beaten the MSCI Euro Index (+6% in local currency terms, +3.7% in dollar terms). Over this period, U.S. economic growth has consistently outpaced the eurozone’s, helping U.S. corporations grow profits faster than their eurozone counterparts.  
But the euro isn’t the only currency that has weakened against the dollar. Since mid-2014, the dollar has strengthened dramatically versus a basket of currencies, as measured by the Fed’s Trade-Weighted Broad U.S. Dollar Index. This trend has hurt U.S. multinationals, which have had to convert foreign profits into (fewer) U.S. dollars. It’s also been a negative for countries and companies issuing dollar-denominated debt, as they’ve been forced to bear higher servicing and repayment costs.
And U.S. investors haven’t been immune to the effects of a more-muscular greenback, which has trimmed their international equity returns when translated into dollars. From May 2014 through August 22, 2019, foreign developed markets have gained 6.6% in local currency terms but just 4.1% in dollars. Similarly, emerging market results have been far more favorable in local currencies than in dollars (+4.1% compared to +0.6%).
There may be some relief ahead for these investors. We think the dollar may be near its peak, which would remove the currency headwind. The dollar may find its momentum arrested by additional Fed easing: The market-implied odds of 75 basis points in interest-rate cuts this year were 55% as of August 23. Historically, dovish Fed policy has weighed on the dollar. On the other hand, further dollar appreciation is also possible if the trade war were to escalate, as times of turmoil tend to drive investors into safe-haven currencies, of which the dollar is the most liquid.  

Policy watch: The Fed’s no match for more trade-war trouble   

Last week, Fed watchers were treated to a double feature. First came the minutes from the July 31 meeting of the Federal Open Market Committee (FOMC)—the group within the Federal Reserve that sets monetary policy. The minutes revealed that most FOMC members viewed last month’s 25-basis-point interest-rate cut as a “recalibration of the stance of policy, or a mid-cycle adjustment.”    
At the same time, there was a marked lack of consensus among the meeting participants:
  • “A couple” of them indicated they would have preferred an immediate 50-basis-point cut in the federal funds rate amid “stubbornly low inflation.”
  • “Several” would have held the line on rates based on their view that the economy “continued to be in a good place, bolstered by confident consumers, a strong job market and a low rate of unemployment.”
The second—and main—Fed event of the week took place on Friday morning. At the Fed’s annual symposium in Jackson Hole, Wyoming, Chair Jay Powell’s highly anticipated speech offered few clues about the Fed’s outlook for interest-rate policy. Instead, Powell merely stated that he and his colleagues “will act as appropriate to sustain the expansion.” Markets were prepared for this ambivalence, because Powell’s prepared remarks had been preceded earlier in the week by comments from both hawkish and dovish Fed officials.
Powell admitted that fitting trade policy uncertainty into a monetary policy framework is “a new challenge,” putting the Fed in uncharted waters. He also emphasized that monetary policy, while a powerful tool for supporting consumer spending, business investment and public confidence, “cannot provide a settled rulebook for international trade.” Rather, he said, the Fed can “try to look through what may be passing events, focus on how trade developments are affecting the outlook, and adjust policy to promote our objectives.”
If the Fed deemed the U.S./China trade war a “passing event” before Friday, the plot thickened that day. China announced new tariffs of 5% and 10% on $75 billion of U.S. imports. Some of the levies will take effect on September 1 and others on December 15, matching the timing of Trump’s previously announced tariffs on Chinese goods.    
China’s retaliation was expected. After all, counterpunching (1) shows strength and (2) provides leverage if and when the two sides return to the bargaining table. (See “Negotiating 101.”) Taking a broader view, with both countries digging in and no high-level talks scheduled, it appears neither one is willing or able to strike a comprehensive deal.
In the wake of China’s announcement, the S&P 500 Index fell 2.6% on Friday, erasing the week’s earlier gains and extending its losing streak to four straight weeks. In contrast, Europe’s STOXX 600 Index carved out gains. European shares aren’t immune to the U.S./China trade war, but they were spared from the “tweet-driven” damage because the exchanges they trade on close at 11:30 a.m. ET. U.S. Treasuries rallied hard, with the yield on the bellwether 10-year note falling to 1.52%.  
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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