BMA Market Insights: Trade Tensions Remain Elevated as Investors Focus on the Fed

New potential trade retaliation from China have market practitioners on edge this week. Concerns surrounding regulators possibly creating a more restrictive environment for U.S. companies operating in China have incited the jitters. Further, market practitioners expect that the Chinese government could discourage Chinese companies and consumers from doing business with U.S. corporates.

Concerns regarding a retaliation hardly come as a surprise, as the Trump Administration blacklisted China’s tech juggernaut, Huawei Technologies, from selling into the American market last week. The Administration intends to possibly disrupt Huawei’s supply chain by preventing the firm from buying semiconductors from U.S. companies as well.

The escalating China/U.S. trade tensions culminated the week to a standstill, with no imminent plans to resume negotiations. If the acrimonious dispute lingers, market pundits warn the economic repercussions not only include potentially lower employment levels and higher prices for the U.S. consumer but a potential 0.5% drop in U.S. GDP next year. Similarly, the estimated damages of tariffs on the Chinese economy is projected to be between 0.5% to 1.5% of GDP.

Weak economic data came out of China last week, namely, disappointing retail sales and industrial production. Given the data was compiled prior to the recent breakdown in trade talks, it is speculated that Chinese officials may enact stimulus measures in the coming months. The Chinese yuan has felt the burden of the escalating tensions, falling about 3% so far this month. A weaker yuan may serve the Chinese well, however, as the depreciating currency could theoretically offset some of the higher levies on Chinese exports.

Not all trade headlines last week were riddled with tension, positive sentiment stemmed with the U.S. postponing tariffs on European and Japanese autos and ending levies on aluminum and steel with its North American trading partners (see more below).

While trade news will continue to drive the markets this week, investors will pay close attention to FOMC Chairman Powell who is scheduled to speak on the risks to the financial system later today. Mid-week, the FOMC Minutes from the April 30th-May 1st meeting will be released. Any insight regarding the Fed’s sentiment regarding trade, transitory inflation or the neutral rate will be keenly scrutinized.

A number of Fed Officials, last week, expressed their concerns regarding the low level of the neutral rate and its implications as to how the Fed may manage monetary policy in future economic downturns. Both understanding the underlying drivers of the neutral rate coupled with changes in the traditional relationship between inflation and unemployment have Fed officials re-evaluating their approach to monetary policy (see more below).

Across the pond, EU Parliament elections will be held late this week. The Eurozone’s policies from trade to immigration could largely be impacted if more populist parties win seats in Parliament. Strong support for the far-right will likely place downward pressure on both the Euro and Sterling. Separately, close attention will also be paid to German GDP and manufacturing data to be released in the coming days.

Last week, the fragile markets roiled by trade concerns drove equity markets lower, with the S&P 500 ending the week around 2,859.53. Similarly, Treasury yields dipped, with the 10-year Treasury hovering around 2.393% at the close. Finally, while demand concerns driven by trade tensions placed downward pressure on oil prices, rising tensions in the Middle East and potential supply disruptions supported energy prices with WTI crude ending the week around $62.71/barrel.

I. U.S. Economic Data/Markets

Michigan Consumer Sentiment survey increased by 5.3% to 102.4, the highest reading since 2004, and compared to forecasts of 97.5. The survey was conducted prior to the recent escalating trade tensions between the U.S. and China.
Fed Official Brainard expressed the risks posed by the potential relationship breakdown between inflation and labor markets. In the past, unemployment at a certain low level would typically incite higher wages and thereby higher inflation.
- Given the current slack in the labor market has not triggered inflation, there is a risk that households and businesses could come to expect inflation to run persistently below the Federal Reserve’s target, which could then change their behavior in a way that reinforces that expectation.
Housing Starts surprised to the upside in April, rising 5.7% to 1.235 million units versus estimates of 1.205 million units.
- Building permits rose 0.6% to a rate of 1.296 million units in April.
Atlantic Federal Reserve cut second-quarter growth estimates to 1.1% from 1.6% on an annualized basis.
Industrial Production dropped in April by 0.5% m-o-m, compared to expectations of a flat reading. Manufacturing output, the largest component of industrial production fell 0.5% over the month given declines in the production of machinery, electrical appliances, and automobiles.
Retail Sales fell 0.2% last month, surprising to the downside, as analysts largely expected a rise of about 0.2%. A decline in automobiles, energy, food services, and building materials purchases contributed to the data.
Fed Official Clarida believed that the economy is running close to the Fed’s dual mandate of max unemployment and price stability. He emphasized the need to reevaluate the Fed’s monetary toolbox and approach to policy, particularly as the level of the neutral rate (where rates neither spur nor temper the economy), has fallen.
- The increased aging population, changes in risk-taking behavior and in technological growth – all have implications regarding the level of the neutral rate.
- If the neutral rate remains low, it may impede the Fed’s effectiveness in loosening monetary policy in times of economic downturns.
- Noted potential change in the traditional relationship between inflation and unemployment.
Fed Official Williams also noted the potential risks of a relatively lower level of the neutral rate across a number of developed economies, including the U.S.
- The limited scope for policy interest rate cuts in future downturns may mean recoveries will be slower, with inflation below target.
- Governments can help boost the level of the neutral rate by raising public and private investment in human and physical capital, infrastructure, science and technology, and policies aimed at removing barriers to participation in the labor force and the economy more broadly.
- Governments can also shorten the maturity of their borrowings during times of financial stress, which may magnify the impact of central bank long-term debt buying.
Fed Official Rosengren expressed it may be premature to have concerns surrounding a recession on the back of the escalating trade conflict between the U.S. and China. He emphasized the Fed’s focus on the near-term and given that time frame the current monetary policy does not need to be altered. He noted, however, that the longer the dispute lasts, the greater uncertainty and potential disruption to trading patterns.

II. Trade

China/U.S. trade tensions continued to escalate over the week. After the Trump Administration imposed higher tariffs on Chinese goods the week prior, China retaliated last week by announcing levies on $60 billion of U.S. goods effective June 1. Both sides appeared at a standstill with no dates set to resume discussions.
- The Trump Administration blacklisted Chinese company, Huawei Technologies, one of the largest telecom equipment maker, making it difficult to do business with U.S. companies.
Japan/EU/U.S. – The Trump Administration decided to delay 25% tariffs on autos and auto parts for six months, as U.S. trade negotiations with both the EU and Japan continue.
Canada/Mexico/U.S. – The U.S. lifted steel and aluminum tariffs on Canadian and Mexican imports. Both the U.S. and Canadian government agreed on monitoring and enforcement mechanisms to prevent steel dumping that might affect prices.
- The move paves a potential smoother path towards the ratification of the revised NAFTA agreement, presented by the three country heads last year.
Brexit – PM Theresa May said she will agree to a timetable for her departure if her Brexit deals get rejected for the fourth time in June. Parliament is scheduled to debate and vote on a withdrawal bill starting June 3rd.
- Technically, under current rules, May cannot be challenged and be pushed out on a no-confidence basis for at least a year.

III. Non-U.S. Economics

Chinese Economy
- Retail Sales fell to a 16-year low, rising 7.2% y-o-y in April, the slowest pace since May 2003. Forecasts were estimated at an 8.6% increase.
  - Clothing sales fell for the first time since 2009, potentially signaling consumers’ concerns regarding economic growth.
- Industrial Production slowed to 5.4% in April y-o-y from a previous reading of 8.5% in March and expectations of 6.5%.
Eurozone Economy
- Industrial Production dropped by 0.1% m-o-m in March. A drop in energy-related products and the production of non-durable consumer goods both dragged on the data. Conversely, production of capital goods and durable consumer goods both increased.
- German ZEW survey fell to-2.1% in May from 3.1% last month – suggesting that market participants expected restrained economic growth over the next few months.
- German CPI increased to 2.1% y-o-y in April versus expectations of 1.6%.
U.K. Unemployment rate dropped to its lowest levels since 1974, falling by 0.1% to 3.8% for the three months ending in March.
Canada’s inflation edged higher as measured by CPI with a 2% y-o-y increase in April, up from 1.9% in March. The data was largely driven by higher gas prices on the back of a recently introduced carbon tax. April’s reading came in line with expectations.

Key data/events this week: