Trade issues were once again a focal point for capital markets during May. While investors came into the month optimistic that a deal with China was nearing completion, things appear to have taken a significant turn for the worse in recent weeks. The Trump administration hiked the tariff rate on certain Chinese imported goods, from 10% to 25%, and also placed export controls on Huawei, a leading technology company which many view as a Chinese national champion. Huawei was placed on a Commerce Department list of companies which are engaged in activities deemed to be harmful to American interests, the consequences of which could result in a ban on the sale of US technologies to the firm. Should this ban be fully implemented we expect that it would be extremely detrimental to Huawei’s business activities.
President Trump also recently announced his intention to place tariffs on Mexican imports in an attempt to reduce illegal immigration across the southern border. The plan called for an initial 5% tariff on all Mexican imported goods which would have increase by an incremental 5 percentage points every month until the administration’s concerns were addressed. As of this writing however, it appears that last minute negotiations have been successful, and the tariffs are not expected to go into effect. Still, just the threat of their implementation took investors by surprise, and in our view added to already heightened uncertainty with regards to how these and other trade related negotiations will play out, as well as their impact upon global supply chains and economic activity.
We believe that the elevated trade related tensions in recent weeks have had a material impact on capital markets and business conditions. While the direct impact of a potential 5% tariff on Mexican imports would likely have been immaterial to the US economy, other potential consequences such as sowing distrust among our trade partners and a lack of clarity for US corporations could be quite problematic. Most observers believed that the US, Mexico and Canada reached a trade deal six months ago, and we cannot help but think that other countries which have recently entered into trade agreements or are in the process of negotiating them might now be skeptical that the terms of those agreements will be honored. Some businesses have reacted to the tariffs on Chinese imports by adjusting their supply chains, in some cases moving production out of China and into Mexico. These companies may have been adversely impacted should the Mexican tariffs had gone into effect, but more broadly this level of uncertainty makes planning very difficult for businesses, and our concern is that some may respond by slowing or freezing hiring and investment. We believe heightened trade tensions played a large role in the S&P 500’s 6.5% decline during May and are also likely contributing to the inverted yield curve.
US economic data appears to be uneven of late. Surveys of the manufacturing and service sectors, while still indicative of growth, have come in below analysts’ expectations. The latest readings on capital goods orders and retail sales have also been soft. As a result, most projections for Q2 GDP are now calling for less than 2% annualized growth. Core growth during the 1st quarter, adjusting for inventories and trade, was sluggish but there was a consensus view that certain one-time items such as the government shutdown, delayed tax refunds, and unfavorable weather conditions were largely responsible, and that growth would accelerate during the 2nd quarter and beyond. This most recent spate of disappointing data has called this view into question. Moreover, the inverted yield curve may be flagging problems ahead. At the moment we do not believe that the inversion has persisted long enough to be considered a reliable indicator of a near-term contraction. However, should it persist for another few months, it would cross the threshold at which past yield curve inversions of similar duration have been very accurate in predicting impending recessions.
There are reasons for optimism. Consumer confidence has held up well. Productivity appears to be strong and inflation remains at low levels. If trade circumstances were to improve, it is possible that an accompanying increase in corporate confidence could pave the way for a solid 2nd half of economic activity. We also believe that the Federal Reserve will not hesitate to use its tools to ease monetary policy if the economic data continues to weaken. The market seems as if it is beginning to anticipate just such a scenario. The biggest risk to markets in our view is that trade related tensions do not subside, and corporate and investor confidence falls during a period in which the economy may already be slowing.
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