Will trade tensions and geopolitical events weigh on markets?

David Joy – Chief Market Strategist, Ameriprise Financial
Weekly markets commentary — June 18, 2018

 

Despite the distraction of everything except economic fundamentals, U.S. equities managed to deliver another week of higher prices, but only by the slimmest of margins. The S&P 500 index rose all of 0.02 percent, its fourth straight week of gains, but had to overcome major developments in monetary, trade and foreign policy to do it. 

As expected, the Federal Reserve increased the overnight rate by another quarter point, its second increase this year. In the process, it signaled the distinct possibility of two more such hikes this year. And despite a median economic forecast of 2.7 percent economic growth this year, and 2.4 percent next, accompanied by a fall in unemployment to 3.6 percent, the Federal Open Market Committee (FOMC) expects no meaningful increase in inflation, forecasting the headline personal consumption expenditure (PCE) to rise by just 1.9 percent this year and 2.0 percent next. It anticipates the fed funds rate rising to 3.4 percent in 2020, with a longer-run rate of just 2.9 percent. 

There was little reaction to the Fed’s decision among bond markets. The yield on the two-year Treasury note rose three basis points on the day to 2.58 percent, while the ten-year note yield rose just one, to 2.97 percent. To the surprise of some, there was little mention by the chair of the strong dollar and its impact on emerging market currencies and growth prospects. The slope of the yield curve continued to narrow, with the 2-10-year spread falling to 37 basis points, its narrowest since 2007. Showing little anxiety, high yield spreads were unchanged following the Fed meeting, and declined twelve basis points on the week.

Investors take note of the ECB's monetary policay and geopolitical events

Arguably, the more important central bank meeting took place on the following day, when the European Central Bank (ECB) announced the phaseout of its quantitative easing program by year-end, in a meaningful step away from the extraordinary stimulus measures enacted in the wake of the financial crisis. In an effort to assuage the more hawkish concerns among investors, the ECB simultaneously indicated its intention to leave interest rates unchanged through the middle of next year, earning praise for having engineered a so-called dovish tightening. The immediate result was a sharp decline in the euro versus the dollar to 1.157 from 1.179 the previous day. The yield on the German ten-year bund also fell sharply, to 0.42 from 0.48 percent. 

Earlier in the week, markets took the U.S.-North Korea summit in stride. Understood as a diplomatic first step, with few expectations of a major breakthrough in the denuclearization of the North, markets were relatively calm, despite intense scrutiny of the meeting and speculation as to which side may have prevailed. 

Trade tensions ramp up and investors around the world take note

But the relative policy calm was shattered late in the week as trade tensions escalated with the U.S. announcement on Friday of tariffs on Chinese goods to take effect on July 6, which was quickly followed by counter measures from China. To the extent that there is a little more than two weeks before the effective date, there is still time for negotiation. But the inexorable march toward a trade war with China took a significant step forward. Stocks fell only slightly on the day, although sectors more exposed to a trade war suffered larger declines, and Treasury yields fell slightly. And the VIX volatility index declined, ending the week just below 12, its lowest level since January. 

One might be excused for overlooking last week’s economic data with the overwhelming focus on policy, but in the U.S. the data was mostly positive. Consumer prices did rise by 2.8 percent year-over-year, the fastest rise in six years, but the increase was in-line with expectations. The core rate rose 2.2 percent, a level last seen one year ago. Retail sales were strong in May for the third straight month, and both small business and consumer sentiment was firm. The one soft report was industrial production, particularly in manufacturing, but the weakness appears to have been the result of temporary disruption in motor vehicle assembly. 

One notably weak sector was energy, which fell 3.6 percent last week, as OPEC (Organization of the Petroleum Exporting Countries) and Russia prepare to meet in Vienna this week to consider an increase in production, although within OPEC there is no unanimity on such an increase. After rising 9 percent on the year through mid-May, energy stocks have since declined 3.6 percent on such supply concerns, as well as questions about the pace of global growth. 

This week’s economic calendar is all about housing, including starts, permits and new and existing home sales. But trade will remain the primary focus.