Markets continue to overlook trade tensions

David Joy – Chief Market Strategist, Ameriprise Financial
Weekly markets commentary — Sept. 24, 2018

 

Markets continue to look beyond the potential negative impact of rising trade tensions and are reacting, instead, to the hard evidence of a strong economy. How long they will be rewarded for doing so is impossible to know, but judging by last week’s advances in risk assets, the prevailing sentiment seems to be that trade will become a headwind when there is empirical evidence that it is hurting growth. In the meantime, the economy looks just fine and that is pushing equity prices and bond yields higher simultaneously. 

U.S. equities rose for the second straight week, and for the tenth week in twelve since the start of the third quarter. During that interim the S&P 500 has climbed 7.8 percent and is now 9.6 percent higher on the year. Last week’s gains came despite the announced imposition of another round of tariffs on Chinese exports. That the initial rate of 10 percent through year-end was not as high as feared reinforced the view that trade fears were overdone, at least for the time being. 

The dollar also fell for the second straight week. Since its high for the year on August 14, the DXY index has declined 2.6 percent, and in the process taken some of the pressure off U.S. exporters and emerging markets. The MSCI EM index climbed 2.2 percent last week, its second straight weekly gain. Notably, the Shanghai Composite index of Chinese stocks rose more than 4 percent. The JP Morgan Emerging Market Currency index rose 2.3 percent. And among developed markets, stocks in both Japan and the Eurozone also climbed for the second straight week. 

Not even another rise in the price of crude oil was enough to dent the bullish sentiment. West Texas Intermediate crude rose $2.10 a barrel last week to close at $70.78 a barrel, the highest in four years. At the dollar’s mid-August peak, the price was $66.00. And oil is trading higher as this week gets underway as the OPEC and friends meeting in Algiers over the weekend ended without any new commitment to increase production to offset the loss of Iranian crude as U.S. sanctions begin to bite.

Strength of U.S economy helping to alleviate trade concerns 

The ability to look beyond the potential harm that a prolonged trade war might bring is insufficient in itself to push risk assets higher. There needs to be a concurrent positive narrative to account for the surge in optimism. And that narrative continues to be the strength of the U.S. economy, particularly in both the labor market and manufacturing, and the resulting strength in corporate earnings. Last week, continuing claims for jobless benefits reached their lowest in 45 years. This comes at a time when the unemployment rate is 3.9 percent and the economy has created an average of 185,000 new non-farm jobs over the past three months, and the number of open positions continues to exceed the supply of available workers. The Markit August PMI report rose for the first time in five months, and this followed the ISM manufacturing report from three weeks ago which reached its highest level in fourteen years. And this has been accompanied by consumer price pressures that have remained moderate, as the year-over-year rise in the CPI fell 0.2 percent in August at both the headline and core levels. 

Bond yields are reflecting the focus on economic strength as well. The yield on the ten-year Treasury note climbed six basis points to 3.06 percent last week, just shy of its high for the year of 3.11 percent reached back in May. At the same time, high yield credit spreads fell to within shouting distance of their tightest of the year.

What’s ahead for the economy and trade talks? 

The Federal Reserve will have something to say about the strength of the economy when it meets this week. Since August 24, when Chairman Powell warned about the dangers of misreading the tightness of the labor market at Jackson Hole, the yield on the ten-year has risen by 25 basis points. But the slope of the yield curve has since steepened modestly from 19 to 25 basis points and stocks have continued to climb. The expectation of two more quarter-point rate hikes this year, and a couple more next year, has been fully priced in. But if the Fed’s posture this week is perceived as leaning more hawkish, risk assets will be forced to adjust, especially with valuations as high as they are at present.

As for trade, the mid-term election is seen by some as a hurdle that must be cleared before negotiations with China can get serious. Others warn that we should be prepared for a protracted standoff that could disrupt supply chains, slow growth, and dent the outlook for earnings next year. Handicapping the likely path forward is to speculate. But while a standoff is apparently where we are right now, the president prides himself on being a dealmaker. If a deal can be struck before any lasting damage is done, the prevailing optimism currently reflected in risk assets could well be given another shot of adrenaline.