June 2018 – Monthly Commentary
In the days and weeks leading up to the recent imposition of tariffs on China, nervous investors sold stocks and pushed bond yields lower. However since the tariffs went into place stock prices have risen, with the S&P 500 just ticks away from its recent high and less than 3% away from an all-time high. Apparently, investors have chosen to look past the immediate trade rhetoric and are focusing on the coming earning season, expecting it to be another terrific one. In addition to the initial $50 billion in tariffs, President Trump is threatening to impose sanctions on another $200 Billion of Chinese goods later this summer. In considering how to best position our client portfolio’s for the fallout from a potential trade battle, we consider the best and worst case scenarios as detailed below.
Obviously, the worst case is that the tariffs turn into a long-term trade war between the U.S. and China, resulting in a pronounced uptick in the price of goods sold in the United States. Pushing inflation higher has been the mandate of the Federal Reserve since the financial crisis ten years ago. However, with inflation now above their targeted 2%, a rise meaningfully above that level is unlikely to be a welcome outcome. Arguably, the Fed has enjoyed engineering inflation higher, but it is unlikely they would equally enjoy the uncontrollable effects of tariff-inflated prices. Some estimate that the uptick in inflation would amount to no more than one or two percent. It is nearly impossible to offer a definitive estimate but what is certain is that a rise of that magnitude would not be welcome by equity investors. In that instance, we expect there would be a meaningful pullback in stock prices. However, we also view the possibility of a meaningful drop in bonds yields as somewhat limited because the inflationary uptick would not likely influence the Fed predisposition to raise interest rates. In fact, it could have the opposite effect and embolden them to raise their target neutral rate.
At the other end of the spectrum, the possibility exists that the trade gambit is actually a net positive for the U.S. We can envision a possibility in which the trade battle is short lived and China opens up their markets to greater competition and improved intellectual property rights. Under this scenario, American corporations would have the opportunity to participate in the rapid growth China has experienced and is likely to continue to experience as it moves from an emerging market into a developed one. In this instance, the Federal Reserve would likely continue with their plan for measured rate hikes and ongoing monitoring of the domestic economy.
What is certain, the U.S. economy continues to grow at a rapid pace as witnessed by the June employment report. For the month, the economy added 202,000 new jobs. That puts the average monthly gain over the last year at just a shade under 200,000. That’s remarkable for this stage of the economic cycle. Even more encouraging, 499,000 people reentered the workforce. Because of those additional workers, the unemployment rate actually ticked back above 4.0% from the prior months 3.8%. While we prefer to see unemployment tick lower, in this instance, we interpret the move as unambiguously positive. This late in the economic cycle the unemployment rate typical ticks up because people are losing their jobs, not because they are being hired.