Fears of a Trade War and US Economic Slowdown

Stocks may very well stay under pressure over the next couple of weeks -- before Q218 corporate earnings are reported -- from fears of a trade war and a related US economic slowdown/recession at some point. 

This week's US economic data are minor, but risk exacerbating slowdown fears.   Two of the bigger releases --  May New Home Sales and Durable Goods Orders -- are expected to fall modestly.  The underlying Ex Transportation Durable Orders are seen rising at a slower pace than in April.  I'd pay attention to the June Richmond Fed Mfg Index (due Tuesday), since it has correctly matched the m/m direction of the Mfg ISM Index (due July 1) so far this year.  The risk is for a decline.

To be sure, fears of a trade war and sharp economic slowdown may not pan out, opening the door for a further stock market rally.  Trump may succeed in getting the EU, Canada, Mexico and China to bend, allowing all sides to declare victory.  And, US economic growth would remain above trend if a slowdown matches the expectations for H218 Real GDP Growth in the Fed's Central Tendencies (see my June 10 blog).

There may be movement on trade behind the scenes.  A NY Post article said the US ambassador to Germany had persuaded the Germans to agree to drop a tariff on US-made cars, but had not yet gotten agreement on trucks.  NY Times and others reported a push by some White House officials to restart direct talks with China.  While the past week's headlines were mostly negative, they could change unexpectedly.

Financial Market Conditions are just mildly restrictive as a result of the 50-BP hike in the Fed Funds Rate so far this year, supporting expectations of only a modest US economic slowdown (see table below).  The jump in oil prices may be exaggerated, since about 5% pts of it happened on Friday in response to the OPEC output decision -- and could be an overshoot.

Market commentators have focused on the flattening in the yield curve (2-/10 Yr Tsy Spread down 9 BPs), as possibly pointing to slower growth ahead.  The flattening may be larger than it looks.  If an estimated 50-75 BP boost in the 10-year yield from the huge Federal Government Deficit is taken into account, the flattening would equal the estimated boost plus the actual 9 BP point narrowing in spread, 59-84 BPs.  But, another possibility is that Trump's tariffs have lifted the trade-weighted dollar, as I've argued in past blogs, which in turn has lowered inflation expectations and spurred large capital inflows from abroad into the longer end of the curve.  In this case, the flatter curve does not have such dire implications for future US economic growth. 

                                                        Financial Market Conditions
                                                          (Change So Far This Year)
10-Yr Tsy Yield            2-/10-Yr Tsy Spread         S&P500          T-W Dollar            WTI Oil Price
  49 BPs                               -9 BPs                             3.0%                   4.1%                       13.4%

Q218 Corporate Profits Should Not Disappoint

The stock market probably will not be disappointed by Q218 Corporate Earnings, due in July.  Consensus looks for another strong quarter, with S&P 500 earnings up 20% (y/y), only a bit less than the extraordinary +26.6% in Q118.   Besides a continuing benefit from the corporate tax cut, most of the macroeconomic evidence is positive.  

The source of strength should come mainly from domestically generated profits rather than from overseas earnings.  Stronger US economic growth and improved margins will be the main forces behind profit gains.  Real GDP Growth should be at least as strong as in Q118, on a y/y comparison, based on the NY (3.0% q/q, saar) and Atlanta Fed model (4.8%) Q218 estimates.  And, core price inflation sped up while wage inflation was steady -- resulting in better margins.  Earnings from abroad should slow, however, hurt by a stronger dollar and slower European economic growth (probably a lagged result of the earlier strength in the euro) than in Q118.

                                                                                                                                          Markit
                                                                                                                                          Eurozone              Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q117            2.0                +65.3                  2.3                              2.7          2.2                55.6
Q217            2.2                +13.1                  3.1                              2.5          1.8                56.8
Q317            2.3                 +6.0                 -1.9                              2.5           1.7               57.4
Q417            2.5               +12.7                 -4.1                              2.5           1.7               59.7

Q118            2.8               +21.5                 -6.6                              2.7           1.9               59.1
Q218            2.8-3.3        +42.0                 -0.9                              2.7           2.2               55.9


                                                       

FOMC Dots Little Changed, PPI More Benign Than Headline

The Fed's economic and policy outlooks barely changed at today's FOMC Meeting.  Whether it hikes the funds rate 1 or 2 more times this year will likely depend on the paths of economic growth, labor market conditions and inflation.   The next hurdle for the stock market will be Trump's imposition of tariffs on Chinese goods, expected to be announced on Friday according to news reports.  A Chinese retaliation will be a negative for stocks.

The Fed's "dots" barely changed between the March and June FOMC Meetings.  Only one participant moved from 3 to 4 hikes for 2018.   There was more of a reshuffling in 2019, but little change in the median expectation of around 3.0%.


                                        Number of Dots Per Expected Funds Rate Level
                                                                       2018
                                                             June               March               
                     2.5-2.75                           1                     1            
                     2.25-2.50                         7                     6
                     2.00-2.25                         5                     6
                     1.75-2.0                           2                     0
                     1.50-1.75                         0                     2       

                                                                       2019
                                                             June                March
                      4.0-5.0                            0                     2
                      3.75-4.0                          0                     1
                      3.5-3.75                          1                     0
                      3.25-3.5                          3                     3
                      3.0-3.25                          4                     2
                      2.75-3.0                          4                     5
                      2.5-2.75                          1                     2
                      2.25-2.5                          0                     0
                      2.0-2.25                          1                     1
                      1.75-2.0                          1                     0
                      1.50-1.75                        0                     1   

The FOMC's Central Tendency for Real GDP Growth was essentially unchanged for both 2018 and 2019.   The only change was that the lower bound for 2018 was raised to 2.7% from 2.6%.  The upper bound remained at 3.0%.   Fed officials still look for a slowdown to 2.2-2.6% in 2019.  The Unemployment Rate outlook is slightly lower, but the inflation outlook was unchanged.

Market commentators have been highlighting the high 0.5% m/m May Total PPI as signaling an inflation problem.  However, this is not the right message from the report.  The underlying part of the PPI -- Total Excluding Food, Energy and Trade Services -- rose a slight 0.1% for the second month in a row.   The report shows the benign inflation story remains in effect.

           
  

Stock Rally Should Not Be Derailed This Week

The stock market may trade cautiously going into this week's two main events -- the Trump/Kim Jong Un Summit (Tuesday) and the FOMC (Wednesday).   But, the rally should not be derailed by them.

While little, if anything, concrete should come out of the summit, both leaders have an incentive to keep the dialogue going.   So, the meeting will likely be termed a success.

With regard to the FOMC Statement, some of the economic description should strengthen from May's, which had focused on the relatively weak Q118.  But, the term "moderate" to describe economic growth will likely remain.  More importantly, there is reason to think the "dots" won't change much either, continuing to indicate expectations of one more 25-BP hike this year (as well as one on Wednesday) -- as the Fed retains its gradual approach to tightening.

The reason to expect little change in the Fed's dots is that economic growth expectations are not out of line with the Fed's Central Tendencies made in March.  The latter call for this year's strength to be followed by a gradual slowing to trend over the following two years.
 
                            Fed's Central Tendency Forecast of Real GDP Growth
                                                  (Q4/Q4 percent change)
                                       2018            2019          2020            Trend
                                       2.6-3.0         2.2-2.6      1.8-2.1          1.8-2.0

Although the Atlanta and NY Fed model forecasts of Q218 Real GDP Growth (4.6% and 3.1%, respectively) are above the Central Tendency expectation for the year, the Q118 pace was below it.   The Fed is focused on the underlying pace, not the quarter-to-quarter wiggles.  For H118, Real GDP Growth is now projected to be 2.7-3.4% -- averaging the NY and Atlanta Fed Q218 projections with the actual 2.2% pace for Q118.  An outcome within the Central Tendency range cannot be ruled out.

The more important question for the Fed is what economic growth will be in H218.  If the Atlanta Fed's Q218 forecast is correct, Real GDP Growth would need to average 2.6% in H218 to hit the upper end of the Central Tendency for the year.  If the NY Fed's forecast is correct, H218 Real GDP Growth would need to be 2.6-3.4% to be within the Central Tendency range.  None of these possibilities can be ruled out.  In any case, Fed officials don't know for sure how economic growth will print either in Q218 or in the rest of the year.  So, they should stay with their plans for gradual monetary policy tightening at least until later this year when the data will indicate slower growth or not.

There are reasons to think Real GDP Growth will slow in the rest of the year.  Some of the Q218 strength is likely a temporary bounce-back from the winter.  The boost from fiscal stimulus should begin to come off.  And, the drag from tighter monetary policy should build.  The NY Fed's model's first projection of Q318 Real GDP is 2.9%.







  

Macroeconomic Background Should Sustain Stock Market Rally into the Summer

There is little US macroeconomic data this week to significantly affect the markets, but headline risks -- Apple's Developers Conference, trade disputes, and Mueller investigation -- remain.  Nevertheless, the macroeconomic background should sustain the stock market's uptrend into the summer, with headline risks likely imparting volatility rather than change in trend.

Real GDP is growing 3.3-4.8% (q/q, saar) in Q218, according to the NY and Atlanta Fed models.  This would put the GDP Growth Rate at 2.8-3.5% in H118.  The above-trend growth is seen in the further decline in the Unemployment Rate in May.

The near-term restraining risk from tighter financial conditions has abated, now that longer-term Treasury yields and oil prices are down from their highs.  The part of financial conditions that is still tightening is the dollar exchange rate.  The higher dollar is in part a response to Trump's tariffs as well as to the relatively strong US economy.  But, the dollar's rise has been modest so far.  And, there is a long lag before it noticeably impacts GDP. 

The factor that could eventually slow the economy is a shortage of labor.  The declines in the Labor Force Participation Rate and Unemployment Rate for two months straight highlight this possibility.  But, this is down the road.

A falling Unemployment Rate risks putting upward pressure on wage rates and lead to more aggressive Fed tightening.   But, it is too soon to say this is a near-term risk.  Although Average Hourly Earnings rose an above-trend 0.3% m/m in May, it follows a below-trend 0.1% in April.  The 2-month average is 0.2%, the same as the average m/m increase so far this year.  The y/y was 2.7% in May, the same as over 2017.

The high 0.3% m/m in the April Core PCE Deflator does not mean the trend in inflation has picked up.  The largest increases among components were Household Appliances and Airfares, reflecting the pass-through of tariffs and higher oil prices -- relative price changes.  Other components did not look threatening.