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Weekly Market Review | Week Ending May 10, 2019

14 May 2019

Clint McGarvin, CFA® | Portfolio Manager/Research Analyst

U.S.

U.S. large caps declined more than 2.1% while small caps were down more than 2.5% last week following a tweet from President Trump that discussed raising tariffs on $200 billion of Chinese goods from 10% to 25%. U.S. negotiators said China had backtracked on previously agreed upon conditions.  One such condition included no longer requiring foreign firms to give trade secrets and technology to China in order to do business in that country. The Trump administration stated they are willing to institute tariffs of 25% on an additional $325 billion of goods and services, which would essentially place tariffs on all imports from China.[i] Tariffs act as a tax on consumers, the tariff is paid by the consumer and not by the manufacturer of the goods and services.

A report published by Goldman Sachs states that 100% of the current 10% tariff has been paid by the U.S. consumer through higher prices, not just on the imported products, but also on competing products. One argument that has been made is that imported goods from China will experience a price cut in order to remain competitive in the consumer market. However, U.S. producers of competing goods have increased prices on their products to increase revenues and earnings, which maintained the post-tariff price on the imported goods. Thus, the U.S. consumer has borne the cost of the tariffs and then some, and not the Chinese producers. The same is expected to happen as the tariffs rise to 25%. The industries most at risk include apparel, footwear, and travel goods of which Chinese imports account for 41%, 72%, and 84% of sales, respectively.[ii] As prices increase, sales decline closely followed by a decline in jobs. Thus, as these three industries experience higher prices due to the tariffs, we would expect to see a decline in sales and jobs.

On the other hand, the U.S. economy appears to be performing above expectations as indicated by the 3.2% growth in Gross Domestic Product (GDP) in the first quarter.  Also, job growth remains relatively high and unemployment low, so the U.S., at least at this point, seems likely to withstand the increase in tariffs for a short-time. If the tariffs remain in place for an extended period of time, the ability of the U.S. and the global economies to continue on the growth path becomes more uncertain. Other factors suggesting the U.S. economy is likely to expand further is the Senior Loan Officer Survey on Bank Lending Practices from the Fed[iii] which showed that despite the turmoil in the fourth quarter, banks have not tightened lending standards.  In fact, they are competing for business in the commercial and industrial (C&I) loan category by reducing their spread on new loans. Additionally, despite the increased competition in the C&I loan space, they have not raised standards on other loans, including consumer loans. Thus, credit creation continues and leads the economy by six to nine months, and we may, therefore, expect the economy to expand through the rest of 2019.

Increased tariffs, as noted above, tend to increase the risk in the economy and markets to the downside. Conversely, Treasury yields declined during the week, with the 10-year Treasury falling 7 basis points to 2.47%, while the 3-month Treasury was flat at 2.43%. Sunday evening Treasury market trading showed a further decline in the 10-year to 2.435%, so the yield curve from 3-months to 10-years is flat.[iv] Recall, that this segment of the yield curve has historically been a predictor of recessions as it inverts. But I stress once again that the inversion must remain in place for an extended period of time, long enough to affect bank lending standards, which showed no tightening during the most recent five-day inversion event in March, per the Senior Loan Officer Survey from the Fed noted above.

International

International developed equities declined about 2.5% and emerging market equities were down about 5.1%. International markets were reacting to the same factors as U.S. markets were, the trade tensions between the U.S. and China.

Alternative

Oil prices declined last week due to fears of a trade war, prior to that oil prices had reached a recent high in April. The April oil price increase resulted in a rise in inflation as illustrated by the Consumer Price Index (CPI). Consumer prices increased a strong 0.3% as energy prices jumped last month led by the 5.7% increase in gas prices. The Core CPI which excludes energy and food was up a much subtler 0.1%.[v]

Summary

The increase in tariffs on Chinese imports will likely increase the risk to the U.S. and global economies and may impact capital markets around the world. The key will be the longevity of the tariffs. If they remain in place for an extended period of time, the risk of a recession will likely increase dramatically since a tariff is paid for by the consumer and higher prices result in lower sales and fewer jobs causing a negative feedback loop. Thus, it’s important to pay close attention to the path of negotiations between the U.S. and China. As long as they come to an agreement or make progress toward an agreement that allows the two sides to end or reduce the tariffs soon, then the strength of the economy will likely continue. Other items to be aware of in the coming week include retail sales figures, small business confidence, and consumer sentiment index as well as industrial production numbers. These data points are all prior to the increase in tariffs, but they will offer a view on the resiliency of the U.S. economy to weather the recent rise in prices caused by the current tariffs.


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[i] CNBC (2019), The cost of Trump’s tariffs has fallen ‘entirely’ on US businesses and households: Goldman. Retrieved from https://www.cnbc.com/2019/05/12/goldman-trump-tariff-costs-fall-entirely-on-us-businesses-households.html
[ii] Yahoo! Finance (2019), ‘Prices go up, sales go down, jobs get lost:’ Apparel Trade Group CEO Sounds Alarm on Tariffs. Retrieved from https://finance.yahoo.com/news/american-apparel-ceo-on-china-trade-162034184.html
[iii] The Federal Reserve (2019), Senior Loan Officer Opinion Survey on Bank Lending Practices. Retrieved from https://www.federalreserve.gov/data/sloos/sloos-201904.htm
[iv] U.S. Department of the Treasury (2019) Daily Treasury Yield Curve Rates. Retrieved from https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield
[v] Bureau of Labor Statistics, U.S. Department of Labor (2019), Consumer Price Index – April 2019. Retrieved from https://www.bls.gov/news.release/pdf/cpi.pdf

 

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