FAQs on the Markets and Economy
Will the escalation in the U.S. –China trade dispute derail the bull market?
While it has been our opinion that investors have recently been too confident over progress in trade negotiations, given the strength of recovery from last year’s correction, we have also warned that consolidation period or pullback in stock prices would be normal. Still, we do not expect a retest of December’s lows. Market declines so far have been modest, and we believe investors to some degree have become desensitized to trade tensions.
Importantly, underlying fundamentals remain positive which should eventually lead to higher stock prices. The U.S. economy is relatively insulated from trade-related impacts and recession risk remains low. Meanwhile, equity valuations are a bit more attractive now.
Our base case expectation for modest but healthy profit growth has also incorporated worst case assumptions of further escalation in tensions with China, and our portfolios have stayed away from export-sensitive sectors of the economy, as well as global regions like Europe that are more exposed to trade disruptions.
Since both sides have incentives to want an agreement, a potential deal between the U.S. and China later this year is still a good possibility. In the near term, though, more twists and turns can be expected and investors should brace for further volatility.
Has the tariff conflict altered your view of what the Fed will do this year?
We continue to believe the Fed is on hold for the remainder of the year. But the escalation of trade tensions has increased some economic risks.
There are several scenarios. The simplest would be a trade deal gets struck within a few months and the tariffs are withdrawn. In this case, the impact on the economy might not be noticed. If the current tariffs stay in place, inflation is sure to rise. The estimates seem to be up an additional 0.2% to 0.4% on an annual basis, depending if other tariffs, which have been threatened, are put in place.
This of course will eat into disposable income and will probably affect consumer confidence, which may alter the consumption habits of many households. The federal funds futures market rallied on the implementation of the tariffs and China’s response. It had already started to price in an easing this year due to low inflationary pressures, but now fully price in a cut due to weaker growth expectations.
Are rising trade tensions with China a threat to the U.S. economy?
Each escalation in trade tensions with China has incrementally weakened the U.S. economic outlook somewhat, but not enough, we believe, to derail the expansion.
Importantly, the U.S. economy is fairly isolated from these pressures, relying primarily on a healthy consumer sector and domestic demand for growth. Exports make up only about 12% of the U.S. economy, and trade with China specifically accounts for only 1% of GDP.
Even if the Trump administration goes forward with its plan to target the remaining approx. $300b of imported Chinese goods, and China retaliates further, the impact should be manageable.
Including the indirect effects of higher prices and reduced confidence, most estimates are that U.S. GDP would be reduced by about 0.4%. For now, a bigger concern is whether or not the U.S. administration begins to turn its attention towards other major trading partners like Japan and Europe, and starts targeting the auto sector.
What do rising trade tensions mean for EM Asia equities?
Although trade concerns may keep markets volatile in the near term, we believe fundamentals remain supportive and indicate we could be poised to begin another cycle of outperformance.
In our analysis, the fallout from U.S.-China tensions on EM Asia economies and corporate profitability is lower than commonly understood. The region’s strong growth outlook is increasingly more consumer and less export driven.
About 60% of China’s GDP, for instance, is now value-added services and consumption, and U.S. exports account for only 3.6% of GDP (down from 7.3% in 2006). In other emerging Asia economies, the negative trade impact should also be relatively small. In fact, some of these economies have received an offsetting boost as U.S. demand has shifted away from China toward alternative suppliers.
Recently, we have seen early signs of improvement in the region’s economic data, and most governments have loosened policy over the past year to help offset the drag from weaker export demand. The worsening of the trade war and the strong fiscal position of most countries increases the likelihood policy could be loosened further.
For investors, EM Asia boasts a superior earnings growth profile, particularly vs. other non-U.S. developed markets. Valuations also look more attractive, both historically and relative to other geographies. Our focus continues to be on sectors and companies that should benefit from domestic structural drivers of demand rather than those exposed to trade headwinds.
What factors are driving strong municipal market returns year-to-date?
Investment grade and high yield municipal bond performance year-to-date is exceptional with the Bloomberg Barclays family of indices posting returns of 3.83% and 4.95% for these market segments, respectively.
A more dovish tone by the Fed coupled with contained inflation data has bolstered investor demand for municipal bonds. Nominal yields have fallen across the curve and compressed valuations of municipal bonds to near-record low levels. For example, a key barometer of municipal attractiveness is the ratio comparing the yield on a 10-year benchmark municipal bond to a comparable duration-matched Treasury. To begin the year, this 10-year ratio was about 85%, but today this gauge has declined to less than 75%. Stretched valuations warrant caution, but the positively sloped municipal curve still provides an opportunity to accrue income.
Underscoring the voracious appetite for bonds is the amount of capital flowing into mutual fund complexes. Since the beginning of the year, net inflows have surpassed $32 billion. The consistent flow of money coming into the market is likely a confluence of Fed policy, in-state demand from taxpayers affected by the limit on state and local tax deductions (SALT), and stable credit quality.
Restrained supply in the market has failed to keep pace with available investment cash flows when including the impact of coupon payments, maturities, and redemptions (see graph). Over the past year, about $60 billion in municipal bond debt outstanding was removed from the market, according to Fed data. The net negative impact of supply is likely to persist this year, helping support municipal bond prices.