Bond markets are closed today in the U.S. and markets may calm down a bit. Trade pressures on China keep rising and it doesn’t have a good way out.

Advantage U.S. but China is in it for the long game. Both sides need to claim victory for a deal to succeed. Stocks continued their slide on Friday as rising interest rates continued to spook investors.

For years now, the Fed and markets have been disagreeing with each other. The Fed, through its FOMC meetings eight times a year, has been telegraphing 3-4 rate increases annually.  But markets have been pricing in fewer.  For quite some time the market has been right.  The Fed went a full year between its first rate increase this cycle and the second.  As recently as mid-2018, many questioned whether we would get more than two this year.  Now it is increasing likely that we will get four, the last one in December.  Moreover, the Fed for quite some time has been stating its expectations of at least three increases next year.  Finally, markets are agreeing.  This catch up, punctuated last week after the most recent FOMC meeting, has led to a sharp short term rise in rates.  The 10-year Treasury yield has risen by about 40 basis points while the 2-year has risen by about 30.  As a result, despite the sharp rise in rates, the yield curve has steepened a bit with the spread rising from just under 25 basis points before the last rate increase to about 35 basis points today. Prior to the FOMC meeting, there were many shouting that the yield curve would invert imminently if the Fed raised rates in September and preannounced several more rate increases in the meetings to come.  The Fed did exactly that but the yield curve actually steepened.  The message is that current economic strength offers no sign of a pending recession.  However, one does have to raise the possibility that too much economic strength and the absorption of excess labor and productive capacity could ignite sharper inflationary pressures than presently expected.  While no one, including us, expects an inflation spike in any realistic sense of the phrase, just a modest increase in expectations could allow interest rates to rise 25-50 basis points over a relatively short period of time.

In addition, the gradual withdrawal of quantitative easing reduces downward pressure on bond yields.  As a result, yields could rise faster than one would expect simply from a modest increase in inflationary pressures.  That, in turn, could have a real economic impact.  In Germany, for instance, industrial production is now down for three consecutive months.  Pressure on industrial production isn’t just a function of ECB monetary policy.  It also reflects trade uncertainty given the tariffs and tariff threats now hanging over the entire economic world.

If there is any category of factors that serves to dominate economic direction more than any other, it is demographics.   Europe has mixed demographic trends, slightly positive in Germany and the more economically efficient northern European countries, poor in the larger southern European nations, and downright awful selectively in some of the weaker nations like Greece.  China and Japan have terrible demographics.  Japan has been experiencing negative population growth for many years and its population is aging as well. China, while better than Japan, is seeing worsening demographics accelerated by its one-child policy that existed for decades.  That policy has also created a sexual imbalance with many more males than females. China has been lauded at times over the years for the efficiency and success of its state-run economic policies.  For many years, it appeared China’s evolution toward open markets and improved governance would accelerate its move toward world economic leadership.  But under President Xi, the country has taken several steps backwards, especially related to the forced turnover of intellectual property to Chinese joint venture partners.  President Trump has forcefully moved to reverse that trend. That has pushed China into an unwanted corner.  While it knows that over time, it will have to move toward open markets and respect intellectual property fully, it wants to do so at its own pace.  Part of its 5-year plan is to become a dominant factor in many key technology and medical fields.  Said a bit differently, it has a goal of developing an intellectual property portfolio equal to or greater than any other nation.  If it were there today, there would be little or no need to steel IP from others or to take other illegal shortcuts.  But it isn’t and, therefore, it will be loathed to agree to any treaty that slows its path to world leadership.  On the other hand, if President Trump can get most, if not all, of the developed world behind it, the American side has most of the cards.  China is much more dependent on exports than we are and it wants foreign investment to help develop its own strengths.  Without the support of world markets, China isn’t going to be able to grow anywhere near 6% with population growth below 1% and falling.

The question for China, therefore, is how does it extract itself from the vice the U.S. and others are tightening with tariffs.  Obviously, in the short run, reduced trade with China and the need to reconfigure supply chains will be disruptive.   Who blinks first?   Obviously, after mid-term elections, there is little reason for us to blink any time real soon.  Our stock and bond markets might get a bit more volatile but it has been Chinese markets that have been taking it on the chin so far this year.  We know from just a few months of history, that President Trump’s bark can be more fierce than his bite.  Ultimately, he wants to be viewed as the President that forced Chinese compliance and set a path for American dominance, at least through the end of his Presidency.  His end goal isn’t tariffs for tariffs sake.  He speaks of using tariffs to reduce our trade deficit but, so far, strong economic growth is raising deficits.  The tariffs so far, including those that might be added in January, could reduce GDP by about a percentage point.  We can all live with that assuming the rest of the underlying economy remains strong.  China would have a tougher time.

With that said, Chinese trade issues go far beyond simply the forced transfer of IP to Chinese joint venture partners.  Any serious agreement will take many months, possibly years.  One should expect a protracted trade battle between the two countries.  Some even suggest a new cold war, played out mostly (but not all) on the economic stage that could last for many years, possibly even decades as China fights for world economic dominance.  One might also argue that our move away from the rest of the world toward a more protectionist, isolation society works in China’s favor.  Every time we lead, China is quick to try and fill the vacuum.

What this all means for markets is a mixed picture.  On the one hand, our economy is very healthy and continues to grow at a nice pace.  Confidence is high both among consumers and industry.  But rising rates and a protracted trade battle with China are headwinds.  Obviously, the forces of these counter pressures will determine the direction of markets over the next 12 months.  My guess is that the end result will be a mild positive but I wouldn’t be surprised, should rates rise further than currently expected, of a slight negative.  The speed of the move upward in interest rates also reminds us of the illiquidity of markets at inflection points.  Markets are all interrelated so a sharp move in bond prices carries over to other asset classes.  Today, is the official celebration of Columbus Day.  Banks and the bond markets are closed in the U.S. suggesting a more muted session.  Chinese markets were closed last week for a holiday and reopened this morning with the Shanghai stock market down more than 3%.

Earnings season starts for real on Friday as several big banks report.  Once again, remember it’s all about results versus expectations.  Expectations are high.  As we have seen from some early reporting companies, simply matching expectations isn’t enough as the good news is already priced in.   Without raised guidance, there is little need for buyers to step in.  I have found that often in earnings season, it is a good idea to have some cash available to buy stocks of companies that miss by a penny or two following by a significant correction on the order of 5-10%.  Assuming the misses are easily explainable and one-off in nature, they can represent great buying opportunities.

Today, Matt Damon is 48.  Chevy Chases turns 75.  Reverend Jesse Jackson turns 77.

James M. Meyer, CFA 610-260-2220

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