Market Insight: Trade, Tweets and Turbulence

Financial markets in the first few months of 2018 have already demonstrated more volatility than during the entirety of last year. While we can never know for certain why markets behave the way that they do, we feel that a combination of geopolitical concerns, rising U.S. interest rates, and economic fundamentals are affecting performance thus far in 2018.

Geopolitical Events

Geopolitical Events

There are two main schools of thought when it comes to Trump administration tactics on trade policy: 1) They view it as a large-scale negotiation with other nations, attempting to secure the best deal for the U.S., or 2) The President does not have the requisite understanding of macroeconomics, and is too easily willing to antagonize our trading partners without thinking through the ramifications. We feel individuals can draw their own conclusion. Regardless, an all-out trade war is something that no reasonable nation desires or is prepared to undertake. In the highest profile case, neither the U.S. nor China can afford an extended period of trade conflict. We have already seen some evidence that the U.S. and China, after some saber rattling, are working together to negotiate trade agreements that benefit both nations while protecting proprietary business interests. The administration is also committed to renegotiating elements of NAFTA with Mexico and Canada. Uncertainty arises from questions of whether a “new” NAFTA could be ratified before this year’s election results change the makeup of Congress.

The on-again, off-again summit between the U.S. and North Korea may yet end up being back on. As the two nations discuss meeting pre-requisites and establish negotiating parameters, markets continue to move with each tweet. If President Trump and Kim Jong Un set aside differences and eventually conduct a meaningful summit meeting, it will almost certainly be positive for markets. If talks break down again, direct military hostilities between the U.S. and North Korea are unlikely. However, any additional provocations by North Korea against our allies in the region threaten both worldwide stock prices and the economic growth prospects of those countries. Kim may have difficulty striking a balance between opening up his country economically and politically while trying to maintain his authoritarian power.

Withdrawal from the nuclear deal with Iran has created some friction with our European allies. Some countries that trade with Iran don’t like our decision to once again impose sanctions (and our expectation that they will abide by them). It is unlikely that a broader break between the U.S. & allies will materialize; however, this uncertainty causes asset prices to fluctuate.

ItalyItaleave? On May 27th, Italian President Sergio Mattarella blocked the formation of a euroskeptic coalition government consisting of the anti-establishment 5 Star Movement and League parties, which have flirted openly with the idea of pulling Italy from the common currency (Wall Street Journal, 29 May 2018).

The move sent worldwide stock prices lower and affected U.S. bonds (positively) and Italian bonds (negatively). Italy’s economy is the third largest in the Eurozone, and eighth largest overall (measured by GDP). If Italy were to move in the footsteps of the U.K. to leave the European Union and the common Euro currency, it would deal a major blow to the Eurozone’s growth prospects and serve as a major headwind to stock markets. However, we are likely a long way from that end result. As of May 30th, there was no resolution yet to the impasse – although both 1) holding brand new elections and 2) negotiating the seating of the original coalition government were both still being considered.

The Federal Reserve sets short-term interest rate policy; however, longer-term rates are driven by market expectations for future economic growth and inflation. Rate normalization by the Fed (a return to historically normal rates, rather than continuing the extremely low rates in place since the last recession) is overdue. Much has been made recently about the “flatness” of the yield curve: the small difference in interest rates between short-term and longer-term bonds. Normally, investors would expect to receive higher interest payments for holding longer bonds, which are considered riskier. However, when long bond rates don’t rise along with short bond rates, it can signal that prospects for economic growth and inflation are muted – producing headwinds for stocks.

Yield curve

Yield Curve

Source: FactSet, Federal Reserve, J.P. Morgan Asset Management. Guide to the Markets – U.S. Data are as of April 30, 2018.

As a result of solid economic fundamentals, we continue to enjoy coordinated worldwide economic growth. Leading the way, the U.S. economy has passed the nine-year mark without a recession, closing in on the longest recorded expansion in our history. U.S. corporate earnings continue to set records, unemployment has dropped below 4%, and inflation remains low. These are all positive developments, but stock markets are driven by the outlook for the future, not the current situation. The trend for corporate earnings in 2019 still appears positive, as labor costs are rising slowly while revenues accelerate. However, it will be challenging for most U.S. companies to continue the rapid pace of earnings growth that has driven stock performance. Last year’s tax policy changes, coupled with regulatory reform, will help. Keep an eye on reported company earnings for the remainder of the year; they should give some signal how stocks will hold up in 2019. International stocks still appear attractive – based on most foreign countries being earlier in their economic cycle, solid corporate earnings, and lower valuations compared to U.S. companies.

Unemployment and wages

Unemployment and Wages

Source: BLS, FactSet, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Guide to the Markets – U.S. Data are as of April 30, 2018.

We constantly analyze current conditions in an attempt to anticipate future market direction, using our own research and that of trusted third party providers. This information assists us in constructing globally diversified portfolios that help you meet your financial goals. As always, please contact us with questions – or just to chat!