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The Trump trade war with China makes it harder to predict economic performance
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Investors are now prone to overreact to any news about tariffs
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The Federal Reserve has its work cut out for it when it comes to interest rate policy
After a period of relative market calm investors have turned jittery, causing wild and unpredictable swings in the market.
Several factors have contributed to the volatility — the unsettled status of the trade dispute with China; mixed signals on the direction of the economy; likely direction of interest rates; and investor impulsiveness.
One of the most significant factors contributing to recent market volatility is continuing uncertainty regarding the status of trade negotiations with China.
Until recently, many analysts and investors believed that any differences between the parties, ultimately, would be bridged.
President Trump’s unexpected and abrupt imposition of a 25% tariff on certain Chinese goods represents an escalation and caught the market off-guard.
Prior to president Trump’s decision to impose tariffs, the U.S. had insisted on several preconditions before any trade agreement could be signed.
These provisions included a promise by China to cease its theft of American intellectual property as well as a demand that China eliminate its long-held policy of forced technology transfer as a condition for companies doing business.
After initially agreeing to these terms, China suddenly reversed course, prompting the 25% tariff penalty for its egregious bad-faith tactics.
Another sign of worsening tensions was Trump’s recent ban on U.S. corporations supplying semiconductor and other memory chips to Chinese telecom giant Huwaei.
The U. S. has alleged the company acts as a conduit for surreptitiously stealing American trade secrets and pilfering other confidential data, including American military secrets.
Presently, the two nations are at an impasse in terms of resolving their trade differences. China is looking to retaliate by imposing tariffs on U.S. imports.
All of these factors are going to impact the economy in ways not yet predictable — ensuring prolonged market volatility.
Unrealistic expectations?
Since January the market has priced in the trade dispute based on the tenuous assumption that any differences between China and the U.S. would be resolved.
Over the past two years, any bad news concerning a lack of progress in reaching an agreement caused declines in the market. Although investor fear resulted in momentary turbulence, the ebb and flow of the market dips were not substantial or disruptive.
That is now starting to change.
The market reached new highs in April, only to be followed by the worst start to May since 1970. A cloud now hangs over the market, with the potential for a repeat of last October’s selloff that resulted from continuing trade tensions and the Federal Reserve’s announcement that it was hiking interest rates.
As the protracted trade negotiations continued, most investors and analysts nonetheless maintained an unwavering conviction that China and the U.S. would come to terms.
The consequences of a trade war would not be in the interest of either country, they contended.
This song and dance has continued unabated for the past two years. During this time, Trump adopted a hard-line stance towards China.
Despite evidence to the contrary, investors ignored Trump’s increasingly adversarial negotiating posture, preferring instead to comfort themselves with the unfounded, even Pollyannaish, assumption that the parties would eventually end the spat and “come together.”
Additionally, Wall Street completely overlooked the strategic and military aspects of the growing chasm in the China-U.S. relationship and the rifts such divergence would have on any trade accord.
Now that Trump has imposed tariffs on Chinese goods, investors who previously had assumed resolution was imminent now react impulsively to any negative news.
Rupal J. Bhansali, chief investment officer for international and global equities at Ariel Investments astutely noted that “the market has been overvalued, not paying attention to any risk; it has been priced for the best-case scenario.”
Now, it will take notice of any risk that materializes with a knee-jerk reaction.”
Adding fuel to the volatility fire, once the Fed reversed course on its projected rate hikes for 2019, many investors believed they were given the green light to jump into riskier assets.
Then it became clear things with China were getting worse instead of better, so investors dumped stock funds and other riskier assets for bonds, adding to the market tumult.
Trump’s sudden 25% punitive tariff, in conjunction with his resolute insistence on conditions that are non-negotiable, served as a wake-up call for investors, analysts and financial journalists alike who were convinced that China and the U.S. would come to their senses and bury their differences.
The shattering of this illusion, prevalent since last December, has all but guaranteed that market instability will ensue.
Fed puzzle
Mixed signals on the economy, combined with uncertainty about how the trade fallout will impact businesses, has made determining interest rate policy more difficult.
Unemployment remains at historically unprecedented low levels and inflation continues to be subdued. Traditionally, when unemployment drops inflation has usually increased, which generally prompts the Fed to hike interest rates to prevent the economy from overheating.
As the 10-year economic expansion continues, inflation has persistently remained low along with unemployment. These unique economic factors have confounded the Fed and made it more difficult to adjust rate policy in a timely manner.
Investors’ expectations for lower inflation has resulted in yields on long-term Treasury bonds dropping below short-term 90 day Treasury bills.
This phenomenon, known as an inverted yield curve has historically been followed by a recession. Yet the inversions have all been fleeting, tempering the predictive power of this phenomenon.
The market has become acutely sensitive to the Fed rate policy, all the more so, as trade enmity continues between the two largest economies, creating enhanced uncertainty about the economic outlook.
The Fed currently has established a target inflation rate of 2% for its “Goldilocks” economy scenario. Inflation has dropped below its target rate twice in the past year, making it even more difficult to ascertain an appropriate rate policy.
In light of slowing global growth, a continuing U.S. expansion and worsening world trade conditions, knowing when to implement a change in rate policy is difficult.
As Minneapolis Fed President Neel Kashkari noted recently, “There’s a cost to the Fed moving rates around a lot. We can add our own uncertainty and volatility to the markets and the economy.”
An accommodative rate policy helps take the sting out of the trade war’s impact on the market. Should the fed announce a policy that is at odds with investors expectations, volatility will increase dramatically.
To make matters even more complicated, the Cboe volatility index (VIX), the markets “fear gauge,” shot up 30% on June 7th, its largest one-day advance since October, when a market selloff occurred.
This is in stark contrast to the recent market surge to new highs on June 11th.
Investors can expect prolonged vacillations in the market during 2019. In light of the deteriorating trade relationship, investors — as well as the Fed — must make decisions based on imperfect information and economic data that at present, cannot predict with specificity, the ultimate effect Chinese retaliatory measures will have on U.S. corporate profits.
Given these imponderables and occasionally divergent signals concerning the health of the economy, adverse news is going to have a disproportionate and potentially outsized impact on the stock market.
Investors should adjust their portfolios accordingly.
