Tariffs Increase Uncertainty and Markets Didn’t Like It
While talk of rising tariffs stoked recent market uncertainty, we believe they should not derail the current robust economic outlook. However, in times of elevated volatility diversification is critical, as is staying active.
As the Fed continues its path of normalization and the US economy moves further toward a later-stage economic cycle, we continue to see increased volatility in equity markets in 2018. This past week was no exception. Heightened volatility was driven by both the Federal Reserve and an unexpected tariff announcement from President Trump.
Jerome Powell’s testimony to the House at the end of February, where he indicated that economic conditions had strengthened since the December FOMC meeting, meant to many market participants that he might consider revising his “dot plot” upward. While the Fed will remain data dependent, it was generally assumed that Powell’s personal inclination was to revisit his projected rate path. This led to a 300-point drop in the Dow followed by a 380-point sell-off the next day, underscoring the market’s sensitivity to the Fed’s rate-hiking path.
Will the Fed shift its projected rate path up in March?
The FOMC median “dot plot” and the markets are nearly converged for 3 rate hikes in 2018.
Source: Bloomberg, as of March, 2018.
Further rattling the markets was President Trump’s surprising announcement of potential import tariffs on aluminum (25% tariff) and steel (10%) later in the week. While ostensibly these tariffs are meant to protect American interests, they create many more questions than answers.
Some implications include:
Broadly speaking, the direct economic impact of the proposed tariffs will not be substantial. Steel and aluminum are inputs to production but the quantity of imports is small relative to the size of the economy, accounting for only about 1.6% of imports or 0.2% of GDP. The tariffs will likely push up prices, but have a negligible direct effect on overall inflation and demand.
Interestingly, the cost benefit of the proposed tariffs seems skewed against steel and aluminum consumers. In 2017, for example, the import value of steel was about $29 billion, while the economy around the consumption of steel, such as the automobile industry, totaled close to $1 trillion.
Impact on allies
The largest countries that the US imports aluminum and steel from are Canada and Brazil, not China, which means we may be damaging relationships with our historically close trading allies.
Will the Fed shift its projected rate path up in March?
Source: Commerce Department, as of December, 2017.
The domino affect
The major unknown is the retaliation that may come from these protectionist measures; we have already seen vindictive commentary out of the European Union, Japan, Korea and China. If retaliation comes in the form of tariffs across other US export sectors, the economic damage could be more substantial, and poses the biggest tail risk to this proposal.
We recently heard from President Trump that he would be open to lowering the proposed tariffs on Mexico and Canada if they are willing to renegotiate a “fair deal” on NAFTA. Thus, the proposed tariffs may only be a negotiating tool for a broader goal of redrafting the NAFTA agreement.
The direction of the White House
There is renewed chatter regarding turmoil in the President’s administration after this announcement. Gary Cohn, White House economic advisor, is rumored to be discontent and possibly leaving the role after disagreeing with the President’s tariff decision.
Overall, the Dow, after falling more than 770 points or 3.1%, was negative for the year at the close of the week. We believe the Jerome Powell testimony is now being overshadowed by a potential trade war, and while it is difficult to handicap the outcome of these events, many analysts believe that this will not devolve into the worst-case scenario of a protracted global trade war. There are large tail risks to a potential trade war, but in a base-case scenario these tariffs alone should not derail the current fairly robust economic and earnings outlook in the US. Nonetheless, uncertainty is high – and markets do not like uncertainty.
We will likely get further clarity next week when President Trump has indicated he will potentially sign the tariffs into law.
During periods of uncertainty we reiterate some of our core views:
Volatility will remain elevated in 2018, as we approach the end of the cycle and global tensions are heightened
Diversification is critical (across equities - domestic and international, fixed income, and alternatives
Stay with active! This is an environment where active managers should shine versus benchmarks
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