The last week’s market highlights:
Quote of the week:
“When elephants fight, it is the grass that suffers.”– African proverb
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: Trump, trade and an unlucky 7 exchange rate
President Trump’s August 2 threat to impose a 10% tariff on $300 billion of additional Chinese goods may not have been described as “the tweet heard ’round the world,” but it still shook up global markets and raised the temperature of the U.S./China trade dispute.
China wasted little time retaliating. On August 5, it instructed state-owned companies to stop importing U.S. agricultural products. And for the first time since 2008, China permitted its currency (the yuan) to weaken below the psychologically important exchange-rate level of 7 yuan to 1 U.S. dollar. (China’s central bank allows the yuan, which is pegged to a basket of currencies including the U.S. dollar, to move 2% in either direction of a “midpoint” that it sets daily.)
This currency counterpunch, which China insisted was not designed to offset the impact of Trump’s tariffs, led the U.S. Treasury Department to label China a currency manipulator, purposely devaluing the yuan in order to gain an unfair trade advantage. (A weaker yuan makes Chinese products cheaper in overseas markets.)
Markets were rattled by these developments last week on fears that the trade war could evolve into a far more dangerous currency war. The S&P 500 Index and Europe’s STOXX 600 Index fell sharply to start the week but recouped some of their losses by Friday’s close. U.S. Treasuries rallied, with the yield on the 10-year note falling 12 basis points (0.12%), to 1.74%. (Bond yields and prices move in opposite directions.)
Are there any benefits to Trump’s upping the ante on trade? Or in China’s “yuan upsmanship”? In our view, the answers to these questions are “no” and “no.”
From the U.S. perspective, the first set of tariffs—25% on $250 billion—targeted Chinese industrial components rather than consumer products. But the 10% levy scheduled to go into effect next month would hit more goods that Americans buy directly, like toys, cellphones, computers and clothes. Making matters worse, the September effective date coincides with when U.S. stores typically begin to stock their shelves for the holiday shopping season. To the extent their inventories include items from China that are subject to the new 10% tariff, those items will be more expensive for U.S. buyers. Moreover, if China shows no inclination to back down, Trump may eventually increase the tariff above 10%, taking an even bigger bite out of consumers’ purchasing power.
Meanwhile, China’s currency devaluation introduces a potentially more disruptive strategy for counteracting U.S. tariffs than it has employed in the past. A depreciating yuan has been known to spur capital flight out of China. In August 2015, for example, China let the yuan decline over a three-day period following the release of disappointing export data. Fearing a sharp economic downturn, investors withdrew cash in record amounts. To prevent the yuan from falling even further and triggering even greater outflows, China aggressively defended its currency in the open market, burning though a substantial portion of its reserve “war chest” in the process. U.S. investors also felt the pain. The S&P 500 fell almost 11% from August 11, 2015 (the first day of the devaluation), through September 28, 2015, before recouping most of those losses by year end.
Chinese currency devaluation can also affect monetary policy worldwide. Last week, central banks in New Zealand, India and Thailand—three countries with deeply global supply chains and strong trade ties to both the U.S. and China—aggressively cut interest rates. Commodity markets may feel the impact as well. The possibility of decreased demand from China sent the price for Brent crude, the global oil benchmark, down almost 9% over the first three days of last week.
Fixed income: What goes up …
Although we’re still in the dog days of summer, the remarkable shifts in global bond markets and Federal Reserve monetary policy bring to mind a moment in the Christmas classic It’s a Wonderful Life, when George Bailey (Jimmy Stewart) exclaims, “This is a very interesting situation!”
Very interesting, indeed. Consider the following:
- What’s up, er, down, with negative yields? Based on the Bloomberg Barclays Global Aggregate Index, the total dollar amount of negative-yielding investment-grade bonds worldwide is approximately $15 trillion—representing more than 27% of the index as of August 8, 2019. (Yields on German government bonds, for example, considered the safest in Europe, were negative across all maturities on that date.) That $15 trillion figure is nearly $15 trillion higher than it was about five years ago, when negative-yielding government debt was quite rare. Investors in such bonds are guaranteed to recognize a loss if they hold the debt to maturity.
- Once an avid hiker, the Fed cuts it out. As of late last week, the market-implied odds of three more Federal Reserve rate cuts by the end of 2019 was just shy of 50%. These would be in addition to the Fed’s July 31 rate decrease. This degree of monetary easing, actual or anticipated, represents a sharp reversal of the Fed’s hawkish policy stance that led it to raise rates just eight months ago, in December 2018, and to forecast up to two further rate hikes during 2019.
- From a 7-year high to a 3-year low. With the U.S. economy gaining steam in the second and third quarters of last year, the yield on the bellwether 10-year Treasury reached a more than 7-year high of 3.24% on November 8. Nine months later, on August 7, 2019, the 10-year closed at a nearly three-year low of 1.71%, as investors flocked to safe-haven assets amid global-growth and trade-war fears.
Also of keen interest to investors is the U.S. Treasury yield curve, which shows the yields on securities across a spectrum of maturities. Typically, yields are higher on longer-term bonds than on shorter ones. But in today’s topsy-turvy fixed-income environment, the yield curve is inverted, with 3-month Treasury bills yielding more than 10-year Treasury notes nearly every day since May 22, 2019. This is a potential red flag because a yield-curve inversion has historically been seen as a harbinger of recession. Moreover, the 3-month/10-year yield differential has shown the most predictive accuracy over time. Indeed, it’s the one most closely monitored by the Fed.
What does the inverted yield curve signify? We think it’s a reflection of the markets’ fear that a global recession could emerge if (1) the U.S. were to impose more and/or higher tariffs, and (2) the Fed were to fail to cut interest rates aggressively enough to offset the negative effects of those tariffs. These would include weaker consumer purchasing power and, perhaps more importantly, lower levels of business confidence, which could trigger a sharp drop in business investment and hiring.
An inverted yield curve isn’t a perfect—or the only—indicator of a potential recession. And history suggests that even when a yield curve inversion does presage a contraction of the U.S. economy, that contraction isn’t likely to materialize until one to two years after the curve inverts.
While we see some risks to U.S. economic growth, including the possibility that the new tariffs (if implemented) could trim second-half GDP by up to 0.25%, we don’t believe growth will turn negative any time soon. Based on our outlook, the probability of a recession occurring in 2020 is about 35%—close to what the yield curve is currently implying.
In the meantime, U.S. consumers appear well-prepared to cope with the slowing but still-expanding economy. Savings rates are high, job openings are plentiful, wages have been rising and asset prices have been climbing for a decade. Consumer confidence will almost certainly fall in August, but from a high level.