- The U.S. economy continues to expand at an above-trend rate, but potential headwinds from trade policies and emerging market stresses are fueling some anxiety in financial markets
- A stronger dollar and U.S. trade sanctions have brought emerging market risks to the forefront
- The Fed is poised to hike again in September, but discussions surrounding the neutral rate of interest and alternative risk management tools have picked up in recent weeks
Financial markets continue to digest a myriad of (conflicting) headlines in an effort to formulate an outlook for the remainder of 2018 and beyond. Trade tensions remain a primary concern, although there were some positive developments in August (e.g., the Mexico trade agreement). Emerging markets have exhibited stress signals, which is not necessarily surprising given what has occurred in currency/commodity markets and trade policies. At the same time, the U.S. economy continues to expand at an above-trend rate, buoyed by tax reform and deficit spending. Monetary policy is a wildcard, particularly the perceived determination of the Federal Reserve to continue forward with policy normalization. A September rate hike is all but assured, but will central bank officials change forward guidance and discuss alternative policy tools, such as activating counter-cyclical capital buffers?
On the data front, July consumption data were solid, and business investment continues to push higher. Regarding the latter, nonfinancial corporate profits rose in Q2 at the fastest year-over-year since 2005 on a pre-tax basis. After-tax profits were even more favorable given the effects of tax reform. As a result, business investment, in contributing more positively to overall economic growth, should ultimately lead to greater labor productivity growth assuming historical trends hold.
Trade & Emerging Markets
Markets responded favorably to the announcement of a preliminary bilateral trade agreement between the United States and Mexico on August 27. Most trade-related headlines in 2018 have been negative, so a positive development was well received. Specifics were limited, but it would be a 16-year agreement with a review every six years. There is a particular focus on the auto sector, including an obligation for car companies to manufacture at least 75% of an automobile’s value in North America, up from the current requirement of 62.5%. The ultimate goal is to roll this deal into a trilateral agreement that would include Canada (NAFTA 2.0), but those negotiations are ongoing. Given the current presidential transition in Mexico, the earliest that this agreement could be formalized and approved is likely in 2019.
While the last week of August started off well with the Mexico agreement, a risk-off theme returned toward the end of the week on further emerging markets concerns and reports that President Trump was prepared to move forward with 25% tariffs on another $200 billion of Chinese goods as early as this week. Regarding emerging markets, Turkey and Argentina have been on the forefront of recent stress, but current risks are more broad across the entire space. Total emerging-market debt has increased form $21 trillion in 2007 (145% of GDP) to $63 trillion (210% of GDP) in 2017, and foreign-currency debt (denominated in dollars, euros, and yen) has doubled to $9 trillion over that same timeframe. Many of these countries have inadequate foreign-currency reserves to cover short-term debt maturities and long-term debt amortization, which requires new debt issuance to cover funding gaps. With the U.S. dollar rallying, this makes foreign-currency debt more expensive, and at the same time, lower expected returns have reduced demand from private institutional investors for local-currency debt. In the graph below, the MSCI Emerging Markets Index (equities) is plotted versus the U.S. dollar index (DXY) over the last 10 years. As the DXY increases, the MSCI typically falls, and vice versa.
The withdrawal of capital from private investors further weakens emerging currencies and devalues asset valuations, and as a result, stress in local banking and credit downgrades typically follow. Emerging market countries can respond by ratcheting up interest rates, which reduces growth and makes the debt burden worse, and if they don’t, weaker currencies effectively import inflation. These countries also typically rely heavily on commodity exports, and commodity prices have fallen in recent months amid a stronger U.S. dollar (the world’s reserve currency for trade). It can be a viscous cycle, and these stresses have been building over the last decade amid vast liquidity and low interest rates coinciding with the ultra-accommodative policies of the world’s largest central banks. As that liquidity is withdrawn, emerging market economies are on the front lines and are the likely first casualties. We haven’t seen a major emerging markets calamity since the 1997 Asian crisis, but analysts and economists are closely watching the current scenario for signs of the next major market event.
The Treasury curve has flattened to current-cycle lows using virtually every slope metric. The 2-year/10-year spread touched 18 bps on August 27th, and the same metric one-year forward was just 10 bps on that day. Many have questioned whether the Fed will continue with current rate hike projections given current yield curve dynamics. A September hike is all but a done deal, and a December hike is looking more certain as well barring any unexpected economic/market shocks. The bigger question is what will come in 2019 for monetary policy: how will the Fed shift its guidance with regards to the natural (or neutral) rate of interest, commonly referred to as R*? Maintaining positive yield curve slope is not one of the Fed’s mandates, and as noted in this commentary on several occasions, an inverted yield curve during a Fed tightening cycle is more the rule, not the exception, in modern history.
The trick, of course, is in determining R*, which is easier to define in the rear-view mirror than it is in a real-time decision-making framework…
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