Trade tensions give stocks and bond yields that sinking feeling

Brian Nick

The last week’s market highlights:

Quote of the week:

“The supreme art of war is to subdue the enemy without fighting.” – Sun Tzu, “The Art of War”
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 2Q 2019 Outlook :
  • U.S. economy: Late cycle but no recession
  • Global economy: Slower this year than last  
  • Policy watch: A dovish turn for global central banks  
  • Fixed income: Rates likelier to rise than fall
  • Equities: Get defensive, stay invested
  • Asset allocation: Still favorable to emerging-market assets

Policy watch: The Fed moves minute by minute

Minutes from the Fed’s most recent meeting, released on May 22, contained few surprises. That should become the norm now that Chair Jerome Powell gives press conferences after each meeting. The minutes reinforced a sense of patience among Fed officials, who noted that the economy’s current mix of “softer” inflation readings and “solid” growth is unlikely to compel immediate changes in monetary policy. Investors looking for even the slightest clue of a rate cut were disappointed. 
Since the Fed last met, both the U.S. and China have raised tariffs on bilateral trade. These reciprocal moves are expected to dampen economic growth in both countries over the balance of the year. But in a series of speeches last week, Fed members remained resolute that the escalating trade war in and of itself doesn’t justify lowering interest rates. For their part, investors seem to be taking the Fed’s rhetoric with a grain of salt; The market-implied odds of a rate cut this year, a mere 2% on March 1, surged to 79% on May 24.  
What might prompt the Fed to cut rates for the first time since 2008? A decision by President Trump to pull the trigger on his threatened 25% tariffs on $300 billion of Chinese imports—many of which are consumer goods. Higher prices on these items could lower real personal spending, and with consumers responsible for about 70% of U.S. GDP, such a decline could get the Fed’s attention.
In contrast, we think the Fed might raise rates only if it believed inflation was in danger of rising well above its 2% target for a prolonged period. Neither the most recent meeting minutes nor any of last week’s speakers raised the possibility that Powell and his colleagues consider tariffs a driver of sustained, sharply higher prices.
Regardless of the Fed’s dovish first-quarter pivot and its current “stay-on-the-sidelines” approach, on May 20, the U.S. dollar surged to its highest level since 2002, measured by the Fed’s Trade-Weighted U.S. Dollar Index. The greenback’s strong 2019 performance demonstrates that the U.S. still represents the “best game in town” for investors, despite a weakening economy and trade row with China. Even with last week’s 1.2% loss, the S&P 500 is among the world’s top-performing equity indexes in 2019. And U.S. Treasury yields continue to exceed those from other developed markets by a wide margin.  
But not everyone is happy about the more muscular U.S. currency. Those saying “nay” include:
  • Countries and companies issuing dollar-denominated debt, which will become more costly to service and repay.​
  • Central banks, which may be forced to raise interest rates in order to defend their local currencies. While that could reduce domestic inflation, it also tends to restrict credit growth and slow the economy.  
  • U.S. multinationals, since they’ll have to convert foreign profits into (fewer) dollars.​​
  • Foreign purchasers of commodities. Commodities are often denominated in dollars and therefore will become more expensive.
We think there’s room for even further dollar appreciation if the Fed remains on hold for the rest of the year. That’s because rate cuts have largely been “baked in” to short-term bond yields, which are more sensitive to Fed action. Although the 2-year Treasury note, for example, closed at 2.17% on May 24, near a 15-month low, similar-dated debt from the eurozone and Japan offered yields of -0.63% and -0.14%, respectively.    

U.S. economy: Who’s consumed by the tariffs?   

Discount clothing legend Sy Syms famously said, “An educated consumer is our best customer.” With a 25% tariff set to hit $200 billion of Chinese goods, and with the U.S. threatening a 25% levy on a further $300 billion, retailers may be hoping that they don’t lose too many consumers—educated or not.
Consumer spending increased just 1.2% in the first quarter, its worst showing since the first quarter of last year. Anyone looking for a bounce to start the second quarter was disappointed, as retail sales unexpectedly fell in April. Still, consumer attitudes stayed upbeat. The Conference Board’s index of consumer confidence increased in April, and the University of Michigan (UMich) consumer sentiment gauge surged to a 15-year high in May, according to the preliminary reading. Notably, the “expectations” components of both surveys were strong.
One caveat to these positive results: Both surveys were taken before the latest flare-up in the U.S. tariff war. It’s quite possible that May’s Conference Board reading and the final May print of the UMich index will be weaker.
With consumers staring down the possibility of a 25% tax on all Chinese imports, we see two possibilities for the U.S. economy, neither of which is very encouraging. First, the savings rate could fall as people buy the same amount of goods at a higher cost. Second, consumer spending growth could decline as people purchase less with the same amount of money.
Retailers, meanwhile, are facing a potential double-whammy from tariffs: higher costs on imported Chinese goods and possibly softer consumer demand for those goods. Last week, a number of key U.S. retailers, including JCPenny, Macy’s, Kohl’s and Home Depot, spoke of raising prices or altering their supply chains. These stores rely on China for up to 20%-30% of their manufacturing needs. And since they plan to absorb at least some of the tariffs, their earnings could fall by 10% to 20%.  
We wouldn’t count out the consumer just yet, though, thanks largely to a still-robust labor market. Annual wage growth has topped 3% for seven consecutive months, job openings are close to their record highs (according to March’s JOLTS report) and the unemployment rate is near a 50-year low. Indeed, in its May meeting minutes, the Fed used the word “strong” a dozen times to describe the labor market. And consumer balance sheets remain sturdy, with low levels of debt and good cash flows.
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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