Caught by the headlines
After a six straight day decline, the U.S. equity market has fallen nearly 6% from its all-time high set last month.
Two key reasons why markets are moving now
First, there is a growing consensus that U.S. economic growth is slowing. Earlier in the year, mixed economic data and the promise of accommodative monetary policy outweighed concern about a potential trade deal relapse. Now, as market participants have become more pessimistic about the economic outlook and interest rates, they perceive less buffer between headline risks and real business activity.
Second, trade wars are back with a potentially harder bite. From the U.S., President Trump announced a new 10% tariff on US$ 300 billion of imports from China, which will come into effect on September 1 if negotiations do not determine otherwise. In turn, China is allowing its currency to depreciate (which induces dollar strength) and has threatened to halt agricultural purchases. These new actions have a higher likelihood of impacting the U.S. consumer, which makes up two-thirds of the economy.
Why does it matter?
We believe the factors underpinning current market volatility threaten three major economic storylines: dollar strength, the U.S. economic trajectory, and the Federal Reserve’s policy.
One of our most important indicators to watch in the ongoing trade negotiations was non-tariff retaliation from China including currency devaluation and increased oversight. On Monday, the Chinese Yuan (CNY) exchange rate fell to 7.0 yuan per U.S. dollar – the weakest in over a decade. The active depreciation of the Yuan against the dollar draws attention to two major considerations. First, it increases the likelihood that disruptive negotiations continue well beyond the end of the year. And second, a weaker Yuan, if sustained, increases import prices for Chinese businesses and consumers, reducing demand and potentially weakening global growth.
The weakness in the global economy has so far been concentrated in the export-focused manufacturing sector, but we see signs that this condition is now spreading to the broader economy. In the U.S., recent surveys within the services sector suggest this very case may be coming to fruition. We do not consider this to be an immediate warning sign for recession – employment growth and household balance sheets remain solid – but it is undoubtedly a concern.
We suspected the second Federal Reserve rate cut would come in September or October, but the ongoing slowdown in service-sector activity growth, the escalation of trade tensions, and the ongoing sell-off in the stock market make us more confident in that view.
We believe the equity markets could continue their decline another 2% or so, until this headline news shakes out. Without any positive catalyst (i.e. positive trade developments or improving economic data), we expect market volatility to continue, credit spreads to widen, the dollar to strengthen, and the Fed more likely to ease again in September.
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