Market Gradients - The Circus of Trade Tariffs, Inflation, and FED

June 2019

It has been an interesting quarter and as we wind down the first half of 2019, as of today, everything is up Equities, Bonds (IG and Junk), Gold, Silver, Real Estate, Preferred Stock, etc. Below I have listed down a few things that I am looking at and their possible implications on Global Markets.

Trade Tariffs

Trump's "but I am very happy with over $100 Billion a year in Tariffs filling U.S. coffers...great for U.S., not good for China!" comment on the 8th of May is wrong and half baked in so many ways. There has been enough research done to show that the full impact of the tariffs will be borne by the US and Chinese consumers. The coffers that are filling up need to be used to provide support to farmers across US who are reeling under lesser demand from China. US has already announced $12Billion last year and $16Billion last month (which includes $14.5Billion of cash payouts) of aid to US farmers.

Effect on Consumers

According to IMF, US and China consumers are "unequivocally the losers from trade tensions". In further research that was conducted by Cavallo, Gopinath, Neiman, and Tang, using price data from the Bureau of Labor Statistics on imports from China, they find that

• tariff revenue collected is borne entirely by the US importers
• there is almost no change in the ex-tariff border prices from China but a sharp jump in the post-tariff import price matching the percentage of tariff

This higher cost is then passed on to the consumer. Only in some cases is the higher cost absorbed by the importer hence resulting in lower profit margins. Further evidence for this can be found in the study done by the New York Fed.

Source: NY Fed

As per the above table, they estimate the per household annual cost to increase to $831. NY Fed based on their studies "have found that the tariffs that the United States imposed in 2018 have had complete passthrough into domestic prices of imports, which means that Chinese exporters did not reduce their prices."

There are two components here:

• Tax Payments - which is the tariff collected at the border which is borne by the US consumer. Let's say, $10 is collected on goods worth $100.
• Deadweight loss - which is tariff induced shift in supply chains. So to avoid tariffs, the US importer might go to a less efficient firm as in Vietnam and incur a cost of say $109. There is no tariff imposed on these goods but the cost borne by the US consumer has still gone up by $9.

Economic theory points out that deadweight loss tends to increase more than proportionally as tariffs rise as importers are forced to look for more expensive alternatives. They conclude saying, "these higher tariffs are likely to create large economic distortions and reduce U.S. tariff revenues."

All this adds to consumer prices and can push the inflation numbers towards the 2% mark although affecting growth in the process. This leads me to the second thing that I am looking at which is wage growth and the possible pass through to the overall inflation.

How is Phillips?

Source: Bloomberg

Late 2017, the Phillips Curve was front and center in every economic analysis. The contention was that Philipps Curve, which establishes an inverse relationship between unemployment levels and wage growth (note, not inflation) was no longer valid and the relationship was broken. While the debate still rages on, 2018 saw a good jump in wage growth after a two-year consolidation around 2.5%. This is when the unemployment rate has been at historical lows.

Looking back at the last 35 years or so, the Phillips Curve has definitely gotten flatter. Notice in the chart above, during the current economic cycle, the blue line (unemployment rate) has moved a lot lower to generate wage increases (red line). There is also a school of thought that the so-called neutral rate of unemployment might be lower than predicted and now that we have hit it, we might finally see sustained wage growth. This purchasing power with consumers could finally feed into the inflation indicators.

FED

Over the past few months, I have been disappointed by the way FED officials have responded to market moves in terms of messaging and policy statements.

I am amazed at the speed of turns and u-turns that the FED members have taken in the past six months. From the U-turn from "long way to neutral" to the current turn from "transitory" inflation to "act as appropriate to sustain the expansion".

FED's mandate is price stability and maximum employment, which can translate into sustainable growth. FED has to take a long term view and stop reacting to stock market corrections and rallies. A 6% correction in May was hardly a thing to warrant a change in language and intention.

FED is also playing into the hands of an unstable head of state and basically giving him a clean chit to go and spread as much mindless disruption (tariffs and international relations) as possible. Coz cuts will push stocks higher, an important barometer of success for the current president.

Given how G20 has played out, the FED will now realize that the dovishness is not warranted after all. The US consumer is doing just fine as shown in the recent retail sales numbers and as acknowledged by the below statement by the FED in June.

"growth of household spending appears to have picked up from earlier in the year"

There is no doubt that business sentiment and in particular manufacturing activity has been slow the past six months. Uncertainty on trade has deterred business investment but the services space (which makes up 80% of GDP) is holding up pretty nicely. The below chart from Bloomberg captures this wonderfully. The white line represents the ISM Manufacturing PMI the blue line is the ISM Non-Manufacturing Index.

Source: Bloomberg

So, what's the color?

The health of US consumer, wage growth and price increases due to tariffs might just be enough to finally take the inflation above the 2% mark. Generally, the strength of the US dollar and lower energy prices might act as dampeners but the recent jump in oil prices will add to higher prices.

Business and in particular manufacturing activity can quickly pick up given the conciliatory tone around trade discussions between US and China.

The below chart shows the FOMC Median Dots in March 2019 (Grey Line), FOMC Median Dots in June 2019 (Green Line), and Fed Funds Futures (Orange Line). No! the Fed Fund Futures is not on a different scale. That's how much the market is squeezing the central bank, three rate cuts in 2019 and a couple more in 2020!!

The markets will find rate cuts tougher to come by and that might lead to a big repricing in UST yields (higher) across the curve. Fixed income has had a fantastic run so far this year with returns ranging from 9 to 15% absolute depending on the duration owned. Might be a good time to lighten some positions in this space.

Equities will get a boost from the G20 outcome but earnings season will start in a couple of weeks and early indicators show an increase in downward earnings revisions. The US-China technology supremacy battle will last through the next decade and given the bipartisan support that "reigning in China" has, the methods might change from squeezing through tariffs to other (saner) methods to achieve the intended outcomes. Generally, I am unable to see a sustained leg up beyond these current all-time highs and the overhang of anticipating too much from the FED and earnings will dampen equity returns.

The views and opinions expressed are of my own and do not necessarily reflect the official policy or position of the organization I work for.