Can’t We All Just Get Along? Trade Wars and Other Unfriendly Events

By Francis P. Rybinski, CFA, Chief Macro Strategist & D. Harris Kere, CFA, Investment Strategist

The third quarter of 2019 can be summed up by the phrase 'lower expectations' as any lingering optimism was reduced throughout the quarter. The main catalyst driving this recalibration of expectations was the bear market in geopolitics bleeding into the economics. As the trade wars intensify, so does their impact on underlying economics. This theme has been evident in the recent pattern of global trade volumes, which have virtually stalled out for most of this year (Exhibit 1). While expectations have been lowered, given the nature of trade and its paralyzing uncertainty, those estimates are still skewed to the downside.

Exhibit 1: Trade spats across the globe are disrupting trade volumes



Source: CBP World Trade Monitor, AAM. As of July 30, 2019.

The bear market in geopolitics intensified over the quarter. In Asia, protests in Hong Kong stole the show, but backstage, a nasty trade spat brewed between Japan and South Korea. In Europe, Brexit continues to cast a pall of uncertainty over the UK economy, while the export machine of Germany is being hurt by ongoing trade tensions. Meanwhile, the US is engaged on multiple trade fronts with varying degrees of success—from a deal with Japan on one end, to the tense standoff with China on the other.

The uncertainty around trade has started to materialize in economic numbers. Not only have global trade volumes stalled, but a precipitous fall in export orders has pulled global manufacturing into a recession. Companies are starting to respond defensively by putting off capital expenditures until more clarity is available. The longer this goes on, the larger the drag from the multiplier effect.

Inflation remains MIA with core PCE staying firmly below the Federal Reserve's 2% target during the quarter. Even wage pressure has abated, as average hourly earning's year-over-year growth rate moderated for the third straight quarter to 3.1% , according to the Bureau of Labor Statistics.

The main question going forward is, "Will these downside pressures continue and will their negative impact seep deeper into national economies (i.e., affect employment, capital expenditures, etc.)?" We think we are already starting to see it; from the plunging global PMIs, a slowdown in global capex due to uncertainty, and a moderating of labor strength in the US.

We view the trade issue as a long, ongoing soap opera of the Trump presidency. Key tenets of a good soap opera are that it never ends, with incremental news flow oscillating the narrative between positive and negative like a roller coaster on Coney Island. That is exactly what we have had with the multiple trade front issues and we anticipate it continuing for political purposes.

Within the context of this moderating economic backdrop, the various central banks around the world have been trying to soften the economic impacts to their relative economies by kicking off a global easing cycle. To that degree, we believe that this easing will be more than just a one or two rate cut 'mid-cycle adjustment' to which Fed Chairman Powell has alluded.

Outlook

We continue to believe that the US economy is in the late cycle and that growth will continue to moderate towards trend. For the second half of 2019, we see growth running at sub -2%, as the pressures from trade continue to be felt. Furthermore, the risk associated with trade skews distribution of risks to the downside.

The labor market has been slowing gradually, which we expect to continue as employers react to the uncertainty caused by trade disputes. Despite slowing hiring trends, unemployment has stayed at cycle lows because growth in the labor force has been slowing as well. Wages appear to be peaking at 3% year-over-year, and if aggregate hours are slowing, then this will pressure aggregate labor income which is the fuel for the consumer. Again, this plays to a moderating economic story. Within this backdrop, we foresee the Federal Reserve cutting rates one more time this year (taking the upper bound to 1.75%) and twice in 2020.

The US economy continues to grow at a moderate pace which traditionally has been a decent environment for risk assets. However, the large degree of uncertainty and the transition to an environment of slower growth is leading to an increase in volatility, causing the market to recalibrate risk premiums. This includes macro uncertainty related to things like tariffs, trade, Brexit and politics. It also includes a shift to slowing growth internationally, including Europe, China and now the US. In this environment of slowing growth with downside skew, at the asset allocation level, we favor a gradual shift to higher-quality assets in general with lower beta exposure compared to earlier in the cycle.

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