At the risk of being repetitive, many of the same issues as in the last installment, with resolution still hard to find.
Despite the positive market reaction to a 90-day deferral by the U.S. in implementing a 25% tariff on a broader group of Chinese exports, this merely delays the issue, as opposed to solving it. This continues the angst investors are already experiencing about the uncertain outcome of this policy, although an extension is certainly preferred to an outright Jan. 1 implementation. Last week, a series of tweets from the President, one in which he referred to himself as a ‘Tariff Man’, seemed to sour sentiment.
U.S./China escalation to ‘new cold war’?
Frictions reached a head due to a side issue that markets reacted to on Thursday. This was the Dec. 1 arrest (in Canada) of the CFO of Huawei Technologies, the world’s largest wireless equipment supplier, and involved in cutting edge and security-sensitive mobile technologies such as 5G. It appears she was charged with fraud related to circumventing sanctions the U.S. has placed on Iran. It’s likely not the event so much as the poor timing and possible further deterioration of relations between the two nations—threatening a deal for the aforementioned trade issues.
While trade issues remain top of mind, a broader softening of global economic growth has risen higher in investor minds. While it’s become a widely-held view that exceptionally strong GDP (3%+) and earnings growth (25%+) levels from 2018 are likely unrepeatable peaks for this business cycle, due to the impact from tax cuts and a lower base, how quickly 2019 growth will temper remains in doubt. Signs of lower growth in Europe and Japan, as well as a challenging domestic market in housing and a few other segments are increasing fears of the ‘R’ word (recession) surfacing—even though many models continue to show this a few years off based on current economic growth levels.
As we’ve mentioned in the past, rates are a simple metric but drive pricing for a variety of assets—small changes can have wider implications. Concerns also flared from a minor/partial treasury yield curve inversion last week, when the 5-year note dipped below the neighboring 3-year and 7-year, while rates remained positively sloped at the longer end of the curve. To investors already somewhat on edge, this was the icing on the cake, although there’s the chance it may look benign in hindsight. In historical literature, a full inversion is a decent measure of forward-looking recession risk, but has occurred consistently across the full curve, being based on 3-month or 2-year yields rising above 10-year yields. Thus far, while the curve has certainly flattened, with the fed funds rate moving higher and long rates staying anchored, this type of full inversion has not occurred. While technicals continue to bear watching for signs of further curve flattening, it appears that inflation breakevens may have played a role, reflecting impacts from dramatic changes in oil prices, which affect CPI. It is important to note that true 10y-3m curve inversions, historically, have occurred well before a recession, and even before a peak in the equity market.
The crude oil market shows tendencies that are a bit of a double-edged sword.
On one hand, equity markets often react negatively to lower oil prices due to the implied lower earnings from energy companies. Bond markets (especially high yield) react similarly, as weaker earnings and cash flows imply income statement pressure, and push down interest coverage ratios, which imply greater risk of bond downgrades and defaults. Additionally, a concern is that lower oil prices are the byproduct of lower oil demand, which would imply a deceleration in global growth.
However, to no surprise, cheaper oil is good news for consumers and large parts of the economy as a whole. As most businesses and individuals are users rather than producers of oil, lower prices (for unleaded gasoline, specifically) have tended to spur more positive consumer sentiment, which can be a catalyst for increased spending generally. Furthermore, with several economic recessions in the past being sparked by oil price shocks, lower prices have tended to decrease recession probabilities, all else equal.
These include Brexit and the Italian budget negotiations, as discussed in previous nots. Beyond the events themselves, which remain a concern due to the uncertainty of potential political outcomes (now that a European court has just ruled the U.K. decision to leave the EU could be reversed), sentiment surrounding sustainability of the EU as a cohesive political and economic union long-term continues to override all other considerations.