Special Market Update: Trade Tensions Escalate

The best course of action amid a prolonged period of trade-related headlines is to avoid acting on emotion.

Key Takeaways

  • Increasing trade tensions between China and the U.S. add another layer of worry regarding the slowing of global growth
  • With the help of the consumer, the U.S. continues its longest expansionary period
  • Bond yields stay lower for longer while equities are resilient in the face of volatility
  • Confirm that your strategic asset allocation is one that you can live with through market volatility

Trade tensions between the U.S. and China, which have been going on for over a year, escalated last week following President Trump's threat to impose a 10% tariff on an additional $300 billion of Chinese goods. As expected, China retaliated, allowing its currency to fall below 7 to the U.S. dollar for the first time in over a decade. This action put global markets on edge ahead of Monday's market open, as investors feared escalating trade tensions could push a slowing global economy into recession.

On Monday, global equities plummeted 1.7% to 4.3%, as fears of an escalating trade war between the U.S. and China intensified. U.S. indexes fell 3.0% to 3.5%, with the Dow Jones industrial average down over 767 points, the tech-heavy NASDAQ off 278 points and the S&P 500 down 87 points. Volatility, as measured by the CBOE Volatility index, surged 40%. Stocks recovered some of their losses Tuesday, after the Chinese central bank indicated that it doesn't intend to start a currency war. However, volatility set in again on Wednesday, as weaker economic data out of Germany and rate cuts by policy makers in New Zealand, India and Thailand indicated growing concern over the outlook for global growth. After a roller coaster session, the S&P 500 finished flat after being down significantly during the day.

What Is the Bond Market Signaling?

Global bond yields continue to decline as investors shift money from stocks to bonds. The yield for the 10-year note, which is down 40 basis points in August, fell below 1.6%, a level not seen since 2016. The 10-year note closed at 1.72% on Wednesday. The German 10-year bond yield declined to -0.60%. The move lower in global yields has been dramatic, and we could see the U.S. 10-year potentially move even lower.

The spread between three-month bills and 10-year Treasuries is at 30 basis points — the most negative spread since early 2019, when trade tensions also surfaced. Historically, an inverted yield curve has generally signaled a contraction in the U.S. economy. In analyzing the cause of this current inversion, the yield curve suggests that Fed policy is too tight.

The market is signaling that the federal funds rate should be at 1.5% by mid-2020. Additional rate cuts of 25 basis points are fully priced in for both September and December.

Keeping Market Volatility in Perspective

While the continued uncertainty around trade is unnerving, it is important to put these types of events into context. Equity markets have been resilient for quite some time, fueled by expectations of more accommodative central banks, led by the Fed. The S&P 500 had recently crossed the 3,000 mark in an environment of slow but positive economic growth and modest corporate earnings growth. Thus, it seems reasonable that the market is repricing the impact of increased trade tensions on an already slowing global economy.

It is clear that the U.S.-China trade relations have worsened, making it harder to see the potential of a big trade deal happening. The impact of the 10% tariff on $300 billion of Chinese imports – if levied – is likely to have a bigger impact to the profit margin of retailers of these consumer goods than on gross domestic product.

On the positive side, the U.S. job market is strong, the U.S. consumer remains healthy, and Congress has just passed a two-year budget deal and raised the debt ceiling, providing the assurance of steady government spending. In addition, we are not seeing a tightening of liquidity as credit spreads, often associated with recessionary periods, remain well behaved. Meanwhile, the Fed is likely to provide two or three more rate cuts by the end of the year to help stabilize the U.S. economy. This leads us to believe that the U.S. economy can deliver real gross domestic product of 1.5% to 2.0% this year and next and avoid a recession.

We believe the best course of action amid a prolonged period of trade-related headlines is to avoid acting on emotion. Our well-diversified portfolio positioning has a neutral weight to equities, with a tilt to U.S. equities relative to non-U.S., and includes bonds and other less-correlated assets to cushion portfolios from trade-related volatility. We will be monitoring developments on this front over the coming weeks and months, and will keep you informed of any change in our forecast.

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