- On August 6, 2019
- Agriculture, china, Chinese, Investments, market update, Markets, President Trump, recession, trade war, Trump, US Dollar
In light of the market reaction to the Fed meeting and escalation of trade tensions with China, I wanted to provide a quick update with some thoughts as markets shifted swiftly over the past week in response to some major global developments. First, at the Fed meeting last week Federal Reserve Chairman Powell announced an interest rate cut of 25 basis points to the target Fed funds rate as expected. This is the first cut in over 10 years and lowered the rate to 2.25 from 2.50, which was already priced in by the market. In addition to the rate cut, the Fed announced an early end to its balance sheet run-off program, aka Quantitative Tightening (QT) a month early to help ease conditions. The market took the announcement in stride, but then sold off sharply during the press conference. Powell’s comments that markets should view the cut as a “mid-cycle adjustment” and not as a signal that the Fed will commence on a more sustained easing cycle and a mention about the possibility of future hikes sent stocks reeling. The stock market sold off hard on these comments, before rallying off the lows to end the day lower by 1%. Both high-beta and defensive consumer staples were hit hardest along with energy and commodities.
The real surprises were in the fixed income and currency markets. The US dollar eclipsed its 2-year highs, which is negative for commodities (oil, copper, gold, etc) and could lead to tighter financial conditions. Treasury yields spiked higher before settling a bit lower, but the real surprise was that the yield curve flattened. Long-rates fell more than short rates, which signals that the market is not satisfied with the cut. The Fed has a history of capitulating to market expectations, so this opens up a strong possibility that we’ll get more cuts. In fact, futures are pricing in another 25 bp cut in September as of this morning.
If that weren’t enough, in the aftermath of the Fed announcement, on Thursday President Trump tweeted that the U.S. would move forward with 10% tariffs on $300 billion worth of Chinese imports beginning September 1. This announcement blindsided the market as recent headlines suggested that discussions were progressing and that tensions were easing. This led to more equity market volatility late last week and retaliation from China on Sunday night. As a direct response to the tariff threat, the Chinese allowed their currency to depreciate substantially against the U.S. dollar. China will also halt U.S. agricultural purchases. These events have certainly escalated the trade war to a new level and incited a flight-to-quality on Monday, as major U.S. stock market indexes fell by 3% or more, and Treasury yields fell to 2016 lows.
The selloff has been swift and severe and serves as a reminder that risk happens quickly. We’ve been writing about slowing data for months, which up until now, had been completely ignored by the stock market. We’re seeing it in PMI’s, manufacturing, capex, shipping, trade, and global data. This is what the bond market has been warning us about. On the other hand, the consumer continues to hold up well, as consumer confidence and retail spending are strong, and unemployment is near 50-year lows. We’re a bit concerned by the fact that both credit card interest rates and debt levels are now at or near all-time highs. This doesn’t jive with the broader level of interest rates, and the level of unemployment, and is certainly not sustainable.
My hypothesis is that growth will continue to slow. The main risk is that the weakness we’ve seen predominantly in the industrial and manufacturing sectors of the economy bleeds over into services and manifests in higher unemployment and lower profits. A protracted trade war magnifies this risk.
Ultimately, I think Fed funds go to 0 before it’s all said and done. The Fed is behind the easing curve compared to the European Central Bank (ECB) and Bank of Japan (BOJ) which both have negative interest rates. Whether or not recent events are enough to tip the economy into a global recession remains to be seen, but we’d like to see an acceleration in economic data before adding more risk.
We’ll continue to maintain our barbell portfolio exposure, which has served our clients well during the recent volatility. We prefer exposure to Technology and defensive bond proxies, Consumer Staples, Utilities, and Real Estate until we see signs of growth reaccelerating. Exposure to precious metals serves as a hedge given the geopolitical backdrop and has performed as real rates fall. Our thinking on fixed income has our portfolios tilted toward higher quality, with exposure to Treasuries and government-backed bonds. As always, we will continue to monitor the incoming data to look to capitalize on opportunities as the markets present them. Thank you for allowing us to work for you, and feel free to contact us with any questions.
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