April 2019 – Monthly Commentary
As we’ve written for the last few years, interest rates across the yield curve are too low given the strong economic backdrop. Testament to its sustainability, the U.S. economy has continued to grow despite the behavior of politicians on both sides of the aisle and the Atlantic Ocean. The sharp drop in interest rates from the fourth quarter of last year through January was due in part to the U.S. government shutdown. That was followed by an even lower yield in March as Great Britain approached their BREXIT deadline. After the U.K. and the E.U. kicked the BREXIT can down the road, U.S. investors returned to complacency and volatility fell out of the stock and bond markets. However, that abatement was not to last as Donald Trump’s attempt to reach a trade and intellectual property agreement with the Chinese fizzled. The market impact has been the same as the previous two episodes; stock prices and interest rates both falling precipitously. Economists and political pundits are forecasting that an outright trade war is unlikely but warn that should such an event come to pass it would be detrimental to the economy.
Earlier this month the Trump administration levied a 25% tariff on an additional $200 Billion of Chinese imports. In response, China will impose a similar tariff on $60 billion U.S. goods shipped to China. The overwhelming majority of those Chinese imports are food and energy. Because the trade balance between the U.S. and China is so lopsided in favor of Chinese exporters, which is the reason for the trade war, a prolonged war is not likely to tip the U.S. economy into recession. But with virtually all Chinese imports being subject to tariff, there’s likely to be an uptick in inflation and some business disruption. A large percentage of goods sold at companies like Walmart and Amazon are imported from China. With their narrow profit margins, neither company will be able to absorb the increased cost of goods sold and will need to pass the cost increase onto consumers. The typical Walmart shopper is a budget-constrained consumer and is in no position pay 25% more for any of their purchases. They will be forced to either buy less of their typical basket of goods or substitute a U.S. made product for the Chinese made good. The latter is, after all, the object of the war. But given the dependence of the American buyers on Chinese made goods, a near term substitution is likely to be problematic. With that, we envision a situation where GDP expands initially due to the heightened cost of goods sold, but GDP ultimately takes a hit because economic activity slows as goods become unaffordable and retailers need to cut costs by firing workers. Trump has been upbeat about the situation and has promised to have a meeting with Premier Xi at the G20 meetings later this month. But that doesn’t ensure that the tariffs don’t start to bite this summer. It’s no wonder the capital markets are in a bit of a panic.
With the risk of failed negotiations rising, speculators have raised the likelihood of a Fed Funds rate cut and now expect a 25 basis point cut by the end of this year and another 25 basis point cut in 2020. In fact, Trump is already calling for the Federal Reserve to cut rates to support the trade war. We are at a loss as to what a rate cut would do for the trade war, but Trump has made it a habit of badgering the Fed to cut rates.
Continuing with the Federal Reserve, the central bank issued a rare warning about the riskiness of the leveraged loan market, warning investors that the credit quality of the broad market has deteriorated and that prices are likely to come under severe pressure in the next downturn. We would take that a step further and spread that warning to the BBB-rated component of the investment grade market. We’ve analyzed more than a few companies that have questionable balance sheets and deem their BBB-rating to be one or two quarters from being downgraded into junk territory. The worry with such a situation is the junk bond buying universe is much smaller than the investment grade universe which is likely to exacerbate an otherwise challenging situation.
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