On Friday, I expected a relatively calm day barring a major outlier employment number. Of course, that is exactly what was reported, a number far ahead of expectations despite continued weakness in the manufacturing sector. Stocks rose by a bit over 1%, an apt celebration, but one that shouldn’t last for more than a day.
This week, the attention moves from November economic data to a two-day FOMC meeting and the possible implementation Sunday of additional tariffs on imported Chinese goods. Overnight, China reported that November exports to the United States were down 23% year-over-year while imports were down just 2%. While tariffs, directly, are part of the reason, the size of the reduction in exports also reflects an ongoing effort by American companies to diversify their supply chains away from China to the rest of the Southern and Southeast Asian diaspora. Thus, the 23% reduction in Chinese exports to the U.S. does not equate to a 23% reduction in Asian exports to our country. Asian exports, overall, are still down but not nearly to that extent.
But the sharp drop in Chinese exports clearly puts some degree of pressure on the Chinese to reach some sort of deal with the U.S. to at least stem the pace of supply chain diversification. At the same time, there is pressure on the U.S. not to implement another layer of tariffs without the prospect of offsetting benefit. While tariffs clearly impact the Chinese economy, they are paid by U.S. importers. They are a tax. Even while the U.S. economy continues to grow at about a 2% rate, corporate profits are not keeping pace, in part, because the lack of pricing power forces U.S. companies to eat part of the costs thus crimping margins. More tariffs will simply increase the pain. The optics of raising tariffs further 10 days before Christmas won’t sit well with the Trump administration or Republicans. One can argue how much direct pain the U.S. consumer will bear as a result of potentially higher tariffs, but it would be a hard argument to say that there wouldn’t be any. Certainly, at the start of an election campaign, Democrats will hammer home and probably overstate the impact. Bah humbug doesn’t get one elected.
Thus, markets are presupposing that somehow there will be no additional tariffs implemented on Sunday. Right now, the U.S. wants China to commit to a huge amount of agricultural purchases, and some acknowledgement that intellectual property rights command more respect, among other demands. China wants a rollback in previously implemented tariffs. Whatever is agreed to is small, temporary, and a place holder to keep negotiations ongoing. It is quite possible, that there will be no deal by Sunday, but that Trump may defer the implementation of additional tariffs under the guise that forward progress in trade talks merit postponing future actions. Whenever a small deal is reached, it is quite possible it will be the last until after the 2020 election.
What that means is that trade uncertainty isn’t going to disappear. As long as Trump remains President, the specter of higher tariffs at any moment in time remains. The likelihood that a broad agreement is reached is small. There simply isn’t enough common ground between democratic capitalism and authoritarian capitalism. Neither side is going to get the other to acquiesce to their way of doing business.
Markets could breathe a sign of relief on Monday if tariffs are postponed. Of course, if they are allowed to go through, markets will take a big one-time hit. Thus, we can view Sunday’s deadline as a binary event with the odds skewed heavily toward some accommodation without any additional tariffs.
As for the FOMC meeting, don’t expect much. Rates are going to remain unchanged. The consensus of committee members will be slightly more dovish than in October but don’t take that to mean much. Fed Funds futures suggest a possible rate increase after mid-2020 but that too should be taken with a grain of salt. Any prediction beyond six months in the interest rate futures market is a stab in the dark and utterly unreliable. What the Fed will do next year will be dictated by the economy. The closer we get to the election in November, the less likely it will be that the Fed changes course, even slightly. Only a huge jump in the inflation rate or a huge decrease in GDP growth can ignite a change after the political conventions.
The employment numbers last week put an exclamation point onto the conclusion that there is no pending recession. While the yield curve is no longer inverted the spread between the two- and 10-year bonds of 20 basis points is still quite modest, suggesting only slow growth. But we have lived in this world for about a decade and it has been fine for stocks. After a roughly 25% gain this year, most of which was a recovery from the sharp drop in last year’s fourth quarter, more modest gains are likely going forward. Without an anticipated recovery in corporate profits, there may be no gains at all. But if the heaviest tariff burden is behind us and government headwinds turn to tailwinds as they often do in election years, there will be some further progress. Over the next six months, the shape of the Democratic platform and the likely nominee will become clearer. That could impact markets directly, especially if the race is competitive. But it is too early to try and discount that. For now, momentum is positive and it should continue into year end.
Today, Felicity Huffman is 57. Donnie Osmond is 62. Judi Dench turns 85. And Kirk Douglas is 103.
James M. Meyer, CFA 610-260-2220