Has a trade truce come too late for the markets?

  • The U.S. and China announced a truce with the intent of deescalating trade tensions at this weekend’s G20 summit.
  • While we expect global financial markets to react positively to the news in the short run, market optimism may be short-lived as evidence suggests that the U.S. economy may have already taken a trade-related hit.
  • We reiterate our recommendation from last week suggesting that investors take a more defensive market position as we expect market volatility to pick up in the weeks ahead.

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This weekend’s G20 meeting in Buenos Aires Argentina comes at a time of various crosswinds in the geopolitical arena.  Of most concern for financial markets was U.S. President Trump and Chinese President Xi’s meeting on Saturday night to discuss the future trade relationship between the world’s two largest economies.  Reports from the widely covered event suggest that the two countries have agreed on a truce in trade related hostilities as a process oriented towards constructively resolving the U.S.’s grievances gets underway.

Market positive likely to be short lived

The trade outcome of this weekend’s G20 summit is likely to be received as a positive development by market participants in the coming week given market positioning following the ambiguity surrounding the U.S. President’s position heading into talks.

As a result, we expect the U.S. dollar to trim recent gains versus hard currencies like the euro, pound and yen and anticipate risk sensitive assets like high yield bonds and emerging market currencies, stocks and bonds to outpace gains comparative U.S. gains in the near term. That said, we believe any risk-on rally is likely to face headwinds as investors turn their attention to the softening economic fundamentals in the U.S.

A host of data releases recently have indicated softening economic conditions in the U.S., a point that we have been closely tracking in our FMA Perspectives over the past few weeks.  Trying to digest a few data points at a time can be tedious and so we have prepared our own combined measure of leading indicators to assess the broad trend in the U.S. economy.

We refer to this as our FMA Economic Diffusion Index where a value above zero represents growth momentum accelerating above its 10-year average; a movement in the opposite direction suggests contraction. What the latest data show is that economic growth momentum (while positive) has faltered from the start of the year despite the anticipated positive effects of tax related stimulus announced last year.

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From a business perspective, our work shows that growth momentum has slowed to more than a two-year low when combining measures such as capital goods orders, credit growth and housing permits.  This has been evidenced in recent headlines raising the alarm bells on softer business sentiment like manufacturing and services sector PMIs.

When considering a broader perspective that encompasses the consumer side of the equation (which accounts for over two-thirds of gross domestic product (GDP) growth) a similar trend has developed as momentum has slowed among household oriented indicators of activity.  Our work corroborates other broad, leading measures of economic activity, notably the OECD’s Composite Leading Index for the U.S. which has shown a turn in economic conditions from the start of the second quarter.

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Market implications

So what does this mean for the markets?  We believe that a near term rally may give way to greater selling pressure in the new year.  Trade related uncertainties have been a major headwind for market sentiment since the start of the year and the positive G20 developments are likely to bolster market optimism as a result.  Logically, the announcement of a truce could ultimately result in the de-escalation in a major market risk-off catalyst (trade dispute) which should propel asset prices higher in the short run as uncertainties abate.

Yet, we believe that the damage related to the trade dispute has already been done and is beginning to become more evident in the data (as noted earlier).  This likely has more to do with the indirect of effects of trade war uncertainties combined with higher interest rates than from the direct effects of the tariffs themselves.

From our vantage point it is hard to find any one market risk-positive catalyst that could outweigh the building negative momentum surrounding the slowing U.S. and global economies.  The effects of the 2017 Tax Act, while widely lauded in some corners, have not contributed to capital investment gains as expected this year and we expect the stimulative effects of tax cuts to likely wane into the coming year.

Further, some have argued that a more dovish Fed (or a more cautious approach in the central bank’s rate hike policy) could give the markets more breathing room to push higher next year.  That said, Federal Reserve policy has historically lagged economic activity and Fed Chair Powell’s more moderate language last week is probably more reflective of the weaker economic data coming in than attempt to let the good economic times ride.

These factors combined with slowing growth momentum in the rest of the world suggest that there are few positive catalysts to drive prices higher in near term.  Therefore, market participants will likely contend with more (and not less) headwinds and uncertainties in the coming year.  Given this perspective, how should investors position themselves ahead of potential levels of heightened market volatility?

As we pointed out in our report from last week, we believe that investors can take three steps to prepare for a potential turn in the financial markets.  First, avoid the temptation to chase individual asset returns (like making the decision to cut winners and keep losers in isolation) at the expense of your broader portfolio performance which can be detrimental to long term investment returns.  Diversification tends to outperform asset selection in the long run.

Second, attempting to time the markets can hinder, not help with long term performance returns.  Studies have shown that some of the best performing days in the markets tend to happen shortly after some of the worst days in the market so remaining fully invested even when markets move lower is key to long-term performance.  Finally, sticking with a mindful dollar cost averaging practice during periods of market volatility can provide practical and psychological benefits.

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