Three Key Thoughts:

New Terms of Trade: Policy, Fiasco or Both?
Markets Diverge (Again)
All Quiet on the Fed Front

We try to tune out the constant drone of noise coming from Washington, for the most part. Only when a policy change might or will have a fundamental impact on the economy, businesses or individuals, do we take notice.

The Tax Cut and Jobs Act, enacted last December, has had an enormously positive impact on corporate bottom lines. By lowering the corporate tax rate by about 40%, corporations now have more cash to pay employees better, invest in business expansion and return more capital to shareholders. These are all positive changes for companies, workers and investors. Estimates for growth in the economy have been marked up as have earnings estimates. And the stock market has reacted as you might expect, boosting prices higher.

The ride got bumpier in the second quarter, however, as the Trump administration rolled out its new approach to trade in full force. No country — no matter how close an ally — was immune from the prospective imposition of sizable tariffs. The biggest target of all is of course China, with whom we arguably have some legitimate reasons to be negotiating better trade terms. But the apparent scattershot approach being taken is problematic on a couple of levels. First, with the only discernible rationale for the tariff talk being domestic political gain, negotiations with our trade partners would be difficult because they can’t tell what we really want. Second, because companies aren’t sure how long these tariffs will be in place (maybe they will change with tomorrow’s Twitter feed…), they are hesitant to invest in or make changes to their global supply chains. So what we end up with is a state of confusion, which isn’t positive for any economy.

Maybe, as some including the President himself, have suggested, we are ultimately targeting a world in which tariffs are very low or zero. If so, that would certainly be a welcome outcome. Another positive result would be a deal with China on intellectual property protections and further opening of their market to US exports. For now, our concern with the trade tactics is that they may offset many of the positive effects of the corporate tax improvements. We aren’t concerned about this in the very short term, as the US economy seems to be running on all cylinders. However, if we look forward a year or two, when our economy is likely to be growing at a slower rate, nearer the long term average, then these trade policy effects could be more detrimental.

While we are sorting out noise from real change, we view the second quarter’s market divergence as akin to the knee-jerk reactions that took place immediately after the election in late 2016. Those reactions were reversed in the first half of 2017. This time, reactions to prospective trade policy, drove US small cap stocks to even more extremes of valuation, while emerging markets were driven down by a stronger dollar and tariff concerns. Yet, the fundamentals in many emerging markets — which are largely driven by growing middle class consumers and supportive government policies — have not changed at all. These domestic consumption stories are largely unaffected by US trade policy and they are likely to persist for many years to come.

The Federal Reserve continued on its gradual tightening path this past quarter, raising short term interest rates by another one-fourth of a percent and continuing to reduce its bond holdings. The bond market took this all in stride, as the Fed’s moves were just as expected. We, like most investors, expect the Fed to continue raising short term rates quarterly, as they have long telegraphed, so long as employment is strong, the economy is good and inflation is around their 2% goal.

The only real excitement in the bond market has been whether we are going to see the yield curve “invert” anytime soon. Often used as a early indicator of a coming recession, a yield curve inversion happens when short term rates are higher than long term rates. Typically, this happens late in an economic cycle when the Fed is raising rates quickly in an effort to slow the economy. Eventually, they are typically successful, inducing a recession.

This time may be a bit different: the Fed is hiking rates slowly, just trying to get them back to a normal level. We believe long term rates are being held down as demand for US Treasury bonds remains high because US yields are the highest among major developed economies. We would be more concerned if we were to see rates on lower rated (“junk”) bonds jump up quickly. In our opinion, this so-called “spread widening” will be a more definitive indicator of an upcoming recession this time around.

For now, investors are getting close to earning a positive real (after inflation) return on short term bond investments. We may yet see the day when holding cash in a money market fund is no longer a losing proposition, but rather a reasonably attractive investment!

In client portfolios, we have maintained our significant weight in international stocks, with a preference for Asia over Europe, because of the better growth characteristics of many Asian economies. And we have held onto US stock positions as the US economy and corporate earnings continue to grow nicely. Finally, on the flip side of this, we remain underweight in fixed income because that strong growth could lead to higher interest rates, which would hurt bond prices.