U.S.-China trade negotiations imploded, causing stock market complacency to quickly evaporate. The ensuing flight to quality has pushed the 3M-10Y yield curve back into inversion, at least temporarily. Two key points to shake out:
- This is a stark reminder that policy-induced volatility is a challenge that investors need to actively manage.
- The macroeconomic impact of trade-related uncertainty is heightened given the late stage of the economic expansion.
The news:
In Asian trading on Monday, May 6, markets were expecting trade negotiators to tie a bow on a trade deal. Instead, trade negotiations began to fray, and by mid-week the deal seemed to have imploded. On Friday, the U.S. increased tariffs from 10% to 25% on $200 billion of Chinese imports. Yesterday, the Chinese retaliated with 20%–25% tariffs on $60 billion of U.S. goods, although some of that reflects existing tariffs that are being increased. At time of writing, it is unclear when, or even if, trade negotiations will continue.
Market reaction:
The S&P 500 fell 2.2% in the week ending May 10, the worst week since December 2018. On Monday, May 13, it fell another 2.4%, the worst day in over four months. Benchmark yields fell, responding to both growth concerns and a flight to quality, with the U.S. 10-year Treasury hitting as low as 2.39%. Given that the 3-month T-bill traded around 2.40% on Monday, this pushed the yield curve briefly into inversion. The VIX, a market measure of expected equity volatility, had been on a downtrend for most of 2019 and at the end of April closed in on 12%, a complacent level seen during most of last summer. On Monday, it spiked above 20. This is well short of the volatility we saw in December (VIX > 35), but the signals from the fixed income market show the same level of pessimism.
Escalation of trade tensions and tariffs*
Jan.–March 2018 
|
25% tariffs on $34B of Chinese imports |
China retaliates 
|
25% tariffs on $34B of U.S. imports |
|
Aug. 2018
|
25% tariffs on $16B |
|
China retaliates
|
25% tariffs on $16B |
|
Sep. 2019
|
10% tariffs on $200B |
|
China retaliates
|
8% tariffs on $60B |
|
May 10, 2019
|
Raises tariffs to 25% on $200B |
|
China retaliates
|
20%–25% tariffs on $60B (effective June 1) |
|
Going forward
|
U.S. threat to impose tariffs on remaining $325B |
*Value of goods and percentages of tariffs are approximate.
Impact on the economy:
There is both not much new here, and a lot that will require close watching. The increase in tariffs on Friday will take time to impact the U.S. economy. There is a grace period for goods in transit. As an example, when the U.S. imposed tariffs of 25% on washing machines from China in January 2018, it took until April for the tariffs to hit the consumer directly. When they did, consumer prices for major appliances went from -3.9% y/y in March 2018 to +8.4% y/y by July 2018 and topped out at over 10% y/y in February of this year. Major appliances make up only 0.08% of CPI and clearly have not been enough to alter the broader trend of muted inflation. But the concern that higher tariffs could erode the consumer’s purchasing power is legitimate, and at the end of the day our economic cycle lives and dies by the consumer. Certainly, consumer confidence is vulnerable to policy uncertainty.
Late-cycle problems:
In January 2018, when rhetoric first turned into reality via tariffs, the yield curve was not inverted. The 3M-10Y spread was over 100 bps. Today it is straddling 0 bps. Another key difference now is business confidence, which has eroded notably since tariff escalation began. Then, the ISM non-manufacturing index stood at 59.4 vs. the latest reading in April of 55.5. Manufacturing sentiment has turned even more dour, falling to a 2.5-year low of 52.8 in April. One hates to be alarmist – after all, both measures are still above the 50/50 boom/bust threshold – but with business confidence on more fragile footing than last year, the risk that policy-driven economic disruption will cause businesses to delay investment or cut back on hiring is significant.
Saying no to complacency:
For an investor it can be difficult to avoid complacency, and yet it is increasingly important as the economic cycle stretches into its 11th year and looks increasingly late stage. The Fed’s move to the sidelines gave us a first-quarter return to low volatility. However, this pendulum may have swung too far as markets now err on the side of pricing a Fed rate cut.
In Q1, the key driver of S&P 500 performance was a recovery of P/E multiples, which finished April at 19.25, back in historically expensive territory. Earnings growth, however, was a modest negative contributor to Q1 S&P 500 attribution. The chart below shows significant divergence between S&P 500 company performance depending on where sales and earnings originate. In other words, equities are increasingly reliant on domestic growth for earnings, and while the U.S. economy may be relatively insulated from direct international growth shocks, our equity market is not.
What we can expect from here:
In the near term, expect headline-driven volatility to continue. China’s delay of tariffs until June 1 may very well signal a hope to salvage a deal in the next several weeks. But for now, the two sides seem quite far apart on basic issues of enforcement and access. Other conflicts including cybersecurity and 5G technology could also interfere with trade-based negotiations. Bouts of complacency should be viewed as temporary, particularly as the 2020 elections near – which could cause U.S. rhetoric to get even more heated.
Bottom line:
The demand side of the U.S. economic data continues to look solid. And yet there is an overarching pessimism in the fixed income market that does not square with the complacency we have seen in the equity market in the first four months of 2019. Business sentiment is fading, trade tensions have clearly flared, and 2020 elections are quickly coming into view. Policy uncertainty remains a very real risk to our economic growth. In the maze of investing, the way toward higher equity valuations remains tougher to see than the myriad risks that could push us back down toward Q4 volatility. The solution needs to prioritize the management of volatility and stability through income.
