It’s summertime. However, the global equity markets are experiencing cold chills. Chills can occur with a fever and cause shivering or shaking.
The problem for stock markets around the world is that trade protectionism is starting to turn feverish as America’s major trading partners are threatening to retaliate against the import tariffs that the Trump administration has imposed so far, with more in the works.
Let’s review the impact on global financial markets:
(1) Currencies. As a result of proliferating trade skirmishes, the trade-weighted dollar has jumped 6% from this year’s low on February 1 through last Friday (Fig. 1). It is now flat on a y/y basis, and about to turn positive for the first time in roughly a year; if the strength continues, it may start to weigh on US corporate earnings.
The currency rout has hit the foreign exchange rates of commodity producers especially hard so far in June: South Africa (-6.0%), Canada (-2.7), Australia (-2.2), and Brazil (-1.1). The Emerging Markets MSCI currency ratio has fallen 1.2% so far in June (Fig. 2).
(2) Stocks. US stock markets have been less rattled by the protectionist saber-rattling than most other ones around the world—until yesterday. That’s because while the US has the world’s largest trade deficit, US exports and imports are relatively small compared to their importance to the economies of our major trading partners. That might be partly because they got used to exporting more and more products to the US without any significant trade barriers.
In addition, the Tax Cuts and Jobs Act (TCJA) passed at the end of last year provided a big boost to consumer incomes and corporate earnings this year. That’s offset any negative economic developments from trade protectionism—so far.
This is all consistent with our recommendation to come back home. Joe and I had been promoting a Stay Home investment strategy during most of the bull market, until late 2016. That’s when we detected more signs of a global synchronized expansion, and when we changed to a Go Global weighting for stocks. On June 4, we flipped back to Stay Home.
The ratio of the US MSCI stock price index to the All Country World ex-US index denominated in dollars jumped to a record high last week (Fig. 3). Using local currencies for the latter, the ratio may be on the verge of breaking out to a record high. Here is the performance derby of the major MSCI stock price indexes in local currencies on a ytd basis through last Friday: US (3.4%), China (1.4), EMU (-0.9), EM Asia (-1.5), EAFE (-1.9), EM (-2.7), Japan (-3.9), and EM Latam (-6.1). Last week was especially bad for China’s stock market, as investors reacted to Trump’s new tariffs on Chinese goods. The China MSCI stock price index fell 3.7% in local currency, while the S&P 500 edged down by 0.9% (Fig. 4).
(3) Bonds. The US bond markets are flashing mixed signals. There’s no hint of an imminent recession triggered by a trade war in the yield spread between high-yield corporate bonds and the 10-year US Treasury note (Fig. 5). On the contrary, the spread has been remarkably stable in a very narrow range around 350bps since early 2017.
On the other hand, the yield curve spread between the 10-year and 2-year US Treasury notes fell to 35bps at the end of last week, the lowest since August 27, 2007 (Fig. 6). In other words, it is close to inverting, a development widely feared to be a sure signal of an imminent recession.
Trump’s threatened tariffs could boost the inflation rate if he implements most of them. Yet the inflationary expectation embedded in the yield spread between the nominal and TIPS 10-year Treasuries has remained steady around 2.1% since the start of this year (Fig. 7). Then again, the flattening of the yield curve suggests inflationary expectations are closer to zilch than to 2.1%.
Meanwhile, the 10-year Treasury yield has remained just below 3.00% since the start of this year despite two 25bps hikes in the federal funds rate, with the Fed’s dot plot promising two more this year and more to come next year (Fig. 8). The potential for inverting the yield curve could unnerve Fed officials, reducing their determination to proceed as planned with monetary normalization. Obviously, if push comes to shove and a trade war erupts, the Fed might be forced to lower interest rates and even to reverse course on trimming its balance sheet.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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