June 2019 - Market Research and Commentary

Trade Dispute Leads to Another Yield Curve Inversion

Tariffs, arguably the most important factor affecting the market, the trade dispute between the United States and China continues on 2019. The two main demands from the United States are that China must revise its industrial policies and compliance laws. While many investors were optimistic a deal could be made, it was announced in early May that the United States planned to increase tariffs on May 2nd by May 10th the United States increased tariffs from 10% - 25%. In retaliation, China plans to hit back with tariffs on $60 billion of U.S. goods beginning on June 1st. These tariffs are again injecting uncertainty and subsequently volatility in the market.

Many investors are trying to avoid this volatile market by substituting their stocks for safer investments like U.S. Treasury Bonds. As a result, we’ve seen bouts of selloffs in stocks in May and a rally in bond prices. The decline in the 10-year Treasury yield caused an inversion in the yield curve during the month of May. These inversions in the yield curve will likely stoke concerns about the likelihood of a recession following an inversion. The Treasury yield curve did not stay inverted throughout the entire month of May. The yield spread between the 3 month and the 10 year was very fluid as we saw multiple points of inversion (albeit brief and at times limited to intraday activity). Quite simply volatility and uncertainty surrounding trade can only be kept at bay for so long. As the chart below shows the stock market responded negatively and swiftly to these concerns.

Chart I - Major U.S. Indices - Two Significant sell-offs during May

Chart I - Major U.S. Indices - Two Significant sell-offs during May

To briefly address the concerns surrounding an inverted yield curve, while an inverted yield curve will likely stoke concerns about a looming recession it is important to note that there are different perspectives when comparing the gaps of short-term vs. long-term Treasury yields. The Fed typically studies the differences between a 3-month Treasury yield and a 10-year Treasury yield. This is the yield curve that is traditionally looked at and was inverted throughout the month of May. However, a large group of investors analyzes the difference between a 2-year Treasury yield vs. a 10-year Treasury yield. The main difference in these comparisons is that the two-year Treasury yield is used by this group as a proxy for the market’s expectations about future interest rates and monetary policy. Throughout the month of May, we have seen numerous predictions that the next move will likely be an interest rate cut, which would decrease the 2-year Treasury bond yield. As the chart below shows, this expectation appears to be priced in with the current, positive difference between the 10-Year Treasury and 2-Year Treasury.

Chart II - Treasury Yield Differences

Chart II - Treasury Yield Differences

This round of tariffs is predicted to have a much bigger impact on the average consumer. When tariffs were first introduced, they were originally targeted at U.S. manufacturers and businesses to cushion the blow for consumers. This second round of tariffs introduced by the Trump Administration should affect consumers more directly, as an increasing number of goods will be taxed. Businesses will respond to these tariffs with higher prices, which will likely decrease consumption.

In the short run, it is not likely that firms will race to shift their production outside of China. It is not just about moving one factory to a new location; there are other variables that play a big role in changing production location like the cost of labor and the cost of a new supply chain, which are both excellent in China. Additionally, in the foreseeable future, we’re likely to see higher prices for an extended period of time before businesses start to think about shifting production because of the costs and uncertainty of doing so. Many are probably wondering, “Will the dispute last for a few more weeks, a few more months, possibly a year?” This uncertainty will likely make business investments fall (and as the Chart of the Month shows, this did happen in Q1 2019).

Quanta, the largest laptop maker in the world, emphasized the difficulties of moving their production plants, “I would very much love to build another plant in the U.S. However, it's not likely to build consumer electronics over in the U.S. as it would be too expensive and there isn't sufficient supply chain support,". This shows how all parties will share the burden of these tariffs; consumers with higher prices and firms with higher costs.

Chart III - Goods and proposed tariff amount

Chart III - Goods and proposed tariff amount

Consequently, stocks plummeted at the beginning of May. But measurements of the U.S. economy continue to point towards growth. Unemployment rates are falling to a half-century low while consumer confidence rates improved in May. Combining this with solid wage growth above inflation points to an increase in consumption, the primary driver of the U.S. economy. This increase in consumption leads to an increase in demand for goods/services which leads to an increase in demand for workers to make these goods/services. This trade dispute emphasizes just how easily a bullish economy can be tipped off by trade disputes between two global powers.

Chart IV - U.S. Unemployment rate 2011 - 2019

Chart IV - U.S. Unemployment rate 2011 - 2019

Chart V - U.S. Wage Growth and Inflation

Chart V - U.S. Wage Growth and Inflation

Additionally, the U.S. economy continues to grow due to an increase in productivity. The efficiency of workers in the U.S. improved in the past 12 months at the fastest rate since 2010! This boost in workers efficiency likely contributed to the gains in wage growth.

While there has been (and will continue to be) a lot of volatility surrounding this trade dispute, we believe the markets will likely stand firm. Unlike the 4th quarter of 2018, the Federal Reserve has said interest rate hikes are off the table for 2019, for now. We have reason to believe the U.S. economy is still on solid ground and has the strength to work through the trade dispute; Q1 2019 growth came in higher than expected, unemployment rates are at an all-time low, monetary policy is static, and surprisingly worker productivity increased in the past 12 months.

One point of caution is the the volatile reactions the stock market has to the trade dispute. The direct effects of the trade dispute on the U.S. economy (for now) are of smaller magnitude than the immediate reactions in the stock market. As discussed above, a volatile market decreases stock prices. In response to this stock market decline, businesses and consumers may begin to lose confidence. This reduced confidence can then lead to less business investment, less consumer spending decreasing U.S. GDP.. Overall, our economy seems strong in most areas besides the trade dispute. The U.S. economy is resilient and its not good to bet against it, but eventually the uncertainty will erode confidence, delayed macro decisions, such as tariffs generally affect more and more businesses. This is a manageable bout of volatility but let’s hope it ends with a trade resolution soon.