Federal Reserve fears trade policy ‘cross currents’ will end the party
This month, the U.S. economy will have been growing for 121 months, the longest run since records began in 1854. Yet history suggests that expansions don’t last forever. What might cause a recession?
Unemployment is at a 50-year low and inflation is subdued and the household-debt-to-GDP ratio is declining. There are few signs of excesses in financial markets like the subprime mortgage lending of a decade ago, but stock markets and real estate prices are propped up by historically low interest rates and the debt of non-financial businesses is at an all-time high of 74% of GDP.
The economy is now largely dominated by the service sector but manufacturers are very dependent on complex and fragile global supply chains, leaving them vulnerable to unpredictable policy changes by governments.
And it is these “cross-currents,” or government policy mistakes, that the Federal Reserve fears may bring the party to an end.
Last week Fed Chairman Jerome Powell was more specific in testimony to Congress — the “cross currents” are largely the result of the Trump administration’s trade wars which are disrupting manufacturers’ supply lines, undermining business confidence and business investment.
“The slowdown in business fixed investment may reflect concerns about trade tensions and slower growth in the global economy,” Powell told the House Financial Services Committee on Wednesday.
“Apparent progress on trade turned to greater uncertainty, and our contacts in business and agriculture report heightened concerns over trade developments,” he added. “Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit.”
Living in the past and out of touch with realities of the modern economy ?
While many economists and businessmen agree that China’s misappropriation of U.S. intellectual property over the years, as well as its policy of forcing companies to disclose proprietary technology as a condition of doing business in China, need addressing, the blunt weapon of import tariffs is unlikely to resolve these issues, and is likely to harm the very U.S. companies they are designed to help, and will do little to alter bilateral trade deficits which President Donald Trump believes need rebalancing.
“Imposing a bilateral tariff on a trading partner is also ineffective to address aggregate trade imbalances (that is, the sum of a country’s bilateral trade balances with all its trade partners) because consumers will just switch their demand to other trading partners that face no tariffs,” IMF economists wrote in a blog this week.
“But this doesn’t mean that tariffs don’t matter. Increases in tariffs would particularly hurt output, jobs, and productivity. And the integrated nature of the current global trade system suggests that a sharp increase in tariffs would also impact other countries, creating a ripple effect from one another and leaving the world economy worse off,” the IMF said.
“Policymakers should therefore continue to promote free and fair trade by undoing recently enacted tariffs and enhancing efforts to reduce existing barriers to trade. They should also avoid policies that distort the economy, such as governments stimulating the economy with additional spending when demand is already strong or heavily subsidizing exporting sectors, that create excessive — and possibly unsustainable — imbalances,” they argued.
In 2017 U.S. manufacturers, especially auto makers, feared disruptions to their business due to Trump’s attempt to renegotiate the North American Free Trade Agreement because so much of their production relied on Mexican inputs. While Nafta has been partially renegotiated, the new U.S.-Mexico-Canada Agreement has not yet been ratified by Congress. Similarly, Trump’s import tariffs on goods assembled in China includes many components made in South Korea or Japan, but that does not shift assembly back to America. U.S. companies just move production to other cheap sources of supply, like Vietnam.
“Trump’s ‘tariff men’ are living in the past, out of touch with the realities of the modern economy,” the Nobel Prize-winning economist Paul Krugman argued this week. “They talk nostalgically about the policies of William McKinley. But back then the question, ‘Where was this thing made?’ generally had a simple answer. These days, almost every manufactured good is the product of a global value chain that crosses multiple national borders.”
The dispute between the U.S. and China over trade policy is so important that a resolution one way or another could mean the difference of as many as 800 points to the S&P 500 stock index, J.P. Morgan’s chief equity strategist Dubravko Lakos-Bujas told MarketWatch in an interview.
“Markets are on thin ice,” when it comes to the impact of potential trade outcomes, he said. “If you have a trade deal, and if the trade deal coincides with one or two rate cuts from the Fed, we see an upside scenario of 3,200-3,300” for the S&P 500 index,” he said.
“If for whatever reason we go down the wrong path, and we get escalation of the trade dispute, then we have a downside of 2,500,” or a 16.6% decline from its record high set July 3.
The importance of getting some sort of trade deal that lowers trade barriers, and gives U.S. companies some certainty over future trade policies, swamps that of Federal Reserve policy or even second-quarter corporate earnings results, due to start being reported next week, because the difference between an escalation of the trade dispute and its resolution is large enough to have an even greater impact than the historic corporate tax cut instituted in late 2017, he said.
The impact of the trade war is already being felt in Asia, where data this week showed China’s exports fell 1.3% year-on-year in June, the first full month of the higher US tariff rate, after a 1.1% increase in May. Similarly, imports fell 7.3% in June, and were down 31.4% from the U.S. And Singapore which is heavily dependent on trade, saw its gross domestic product unexpectedly shrink an annualized 3.4% in the second quarter, the biggest decline since 2012
Caution: second quarter earnings ahead
The impact of the trade war may be seen in U.S second-quarter earnings when reporting starts next week. S&P 500 index SPX, +0.46% companies look set to suffer the first earnings recession in three years, led by year-over-year declines in the materials and technology sectors, according to Factset analyst John Butters.
The negative outlook comes after a 0.29% EPS decline in the first quarter. An earnings “recession” is often defined as two straight quarters of declines.
The S&P 500 started the last earnings recession with a 6.9% tumble during the third quarter of 2015, but rose the next three quarters for a total gain of 1.7% during the four-quarter streak of EPS declines.
“The time has come to put our money where our mouth is,” Morgan Stanley chief cross-asset strategist, Andrew Sheets said in a research note. “ In light of these concerns and others, we are downgrading our allocation to global equities from equal-weight to underweight. The most straightforward reason for this shift is simple – we project poor returns.”
“Our concern is that the positives of easier (Fed) policy will be offset by the negatives of weaker growth,” he said. “We think a repeated lesson for stocks over the last 30 years has been that when easier policy collides with weaker growth, the latter usually matters more for returns.”
“For trivia fans out there, July 13-October 12 has historically been the worst 90-day period for equity returns since 1990, possibly because liquidity and risk appetite tend to worsen after 2Q results” he added.
The Federal Reserve is widely expected to cut interest rates at its next meeting in late July and possibly again later this year.
Some analysts remain optimistic though, arguing that a pre-emptive interest rate cut as insurance against recession can work.
“The first Fed cut, when U.S. is not in recession, is a huge deal. 100% of the time we see a rally three months, six months, nine months, and 12 months out,” Thomas Lee, managing partner and head of research at Fundstrat Global Advisors said.
“And the nine month median gain is 18%, implying 3,300-3,400 for S&P 500”
“The bottom line: The macro news from Europe is unsettling, but we are still bullish on US equities into year end. Our view remains 2009 is the best analog for 2019 and argues this year is the start of a new bull market — I know it sounds odd.”