“Your margin is my opportunity.” — Jeff Bezos
Second Quarter Highlights
Market volatility continued throughout the second quarter. An initial downdraft in equities eventually gave way to a rally in the U.S., which faded by the end of the quarter. Foreign stocks finished lower and Treasury prices dipped overall, though much of the decline was reversed in late June. Commodities were mixed again, with gold and copper falling and oil rising sharply. Also confounding the consensus was the U.S. dollar, which appreciated strongly after bottoming in February.
First quarter earnings were very good – in fact, the best in several years — but they had little effect on trading, as investors had shifted their focus to other issues.
He (Trump) Said — Xi (Jinping) Said
Chief among recent concerns were the continued tension between America and its major trading partners — China in particular. To date, a 25% tariff on $50 billion of Chinese imports has been followed by a 10% tariff on $200 billion, with the possibility of the remaining $200 billion or so of Chinese imports subject to duties in the future.
The Chinese government cannot further directly retaliate since they buy only about $115 billion of American exports. They are also wary of letting the yuan depreciate too quickly, as this may cause massive capital outflows and further destabilize their financial markets. Selling their massive Treasury holdings would be counterproductive, since it would hurt both sides equally. Nevertheless, the Chinese can still apply pressure to individual U.S. companies that do business within their country.
Overall, the actions of China and other major trading partners have only had a small direct impact on the $18 trillion American economy, which makes up almost a quarter of global GDP (Gross Domestic Product) and is growing at the fastest rate within this current economic cycle. Indirect effects, such as disruptions in industries with global supply chains remain largely unknown at this time. However, if the uncertainty from the trade conflict seeps into consumer or business confidence, economic growth could be impacted in a significant way.
Federal Reserve Policy and the Economy
Although the central bank continues to gradually raise short term interest rates, the June meeting revealed the country could see two more increases this year. Equities sold off, as some economists speculated the yield curve could soon invert and eventually cause a recession.
While this may be of some concern, a few things should be noted. First, long rates have been recently held down by a number of factors, some of which are transitory and should be receding soon, including foreign central bank buying and a spurt in pension fund purchases due to the new tax law. In addition, the three-month to ten year spread that best predicted past recessions, is currently nowhere near inverting.
Other valuable indicators, such as money supply growth, housing and high yield spreads, are also in good shape. And though conventional wisdom holds that engineering a soft landing in the economy is not possible, the Fed has actually done so three times in the last six rate hike cycles.
The key takeaway from all this is that Fed tightening cycles have always led to economic slowdowns of some magnitude, although not all of them were recessions. Nonetheless, we will continue to monitor Treasury yield spreads and other economic indicators closely for signs of a significant deterioration.
Aiding Chairman Powell with his gradualist rate increase approach is the slow pickup in inflation, which has only recently hit the Fed target of 2%. A contributing factor is the possible slack in the labor force. Also, many companies are not passing along higher costs fearing the loss of customers, a phenomenon especially evident among packaged food companies.
Though equity valuations are now more reasonable than they were earlier and earnings continue to grow, markets are expected to be choppy for a while longer. Trade tensions and anxiety about the pace and extent of Fed tightening will likely keep the S&P 500 in the trading range it has been for most of 2018. Until global issues stabilize, a well-diversified portfolio still remains the best way to navigate through the current uncertain investing environment.