As April came to a close, we learned some key lessons this month about the likely path forward for central banks, the growing concerns about protectionism, and the market’s sensitivity to any changes in key indicators. Below, I highlight five key takeaways from April, and preview five things to watch in May.
Five takeaways from April:
- Central Bank divergence. The Bank of Japan (BOJ) surprised central bank watchers everywhere by removing the timeframe it had set for meeting its inflation target. The BOJ’s objective in making this change was to manage expectations; it felt that markets had begun to view the timeline as a hard deadline rather than a forecast. Similarly, last week saw a European Central Bank (ECB) meeting in which monetary policy apparently was not discussed, according to ECB President Mario Draghi. Instead, Draghi said that the ECB Governing Council focused on the state of the eurozone economy given that “it’s quite clear that since our last meeting, broadly all countries experienced, in a different extent of course, some moderation in growth or some loss of momentum.”
Key takeaway. While BOJ Governor Haruhiko Kuroda said he believes the economy can still hit the inflation target by fiscal 2019, the BOJ is clearly concerned that it will be boxed into expectations of tightening by next year. It wants to have more flexibility, which make sense, particularly given that there are downside risks to its inflation outlook. This could very well mean that the BOJ stays ultra-accommodative for even longer. Meanwhile, the ECB seems far from finishing the tapering of quantitative easing – and even farther from raising rates. But I think it’s worth noting that’s not the case with other central banks. The Bank of China tightened monetary policy, and the U.S. Federal Reserve Bank appears to be moving full speed ahead with rate hikes. This sets us up for an environment in which some central banks have created an environment that is far more supportive of risk assets than others.
- Protectionist fears continue. Although media attention seems to have abated, tariffs continue to be a significant concern – for businesses and central banks. Following last week’s ECB meeting, Draghi explained that the impact of protectionism is unknown at this juncture, given that much of it is just threats at this point, but that protectionism can “have a profound and rapid effect on business, on exporters’ confidence … and confidence can in turn affect growth.” When the Federal Open Market Committee (FOMC) minutes were released in April, we learned that the Fed also worried about the effects of protectionism at its March meeting. And we of course saw concern about tariffs in the most recent Federal Reserve Beige Book, with business leaders expressing concerns that input costs are going up. Several weeks ago, the Brookings Institution released a piece written by David Dollar and Zhi Wang on the potential negative impacts of a U.S.-China trade war. It underscored the potential for costs to increase because some of the items on the tariff list are “parts” – in other words, products used as inputs into a final product.
Key takeaway. Protectionism could not only significantly increase costs to consumers but render such final products less competitive. None of this is supportive of free trade or economic growth.
- Fears that earnings are as good as it gets. Corporate earnings have been improving for multiple quarters, with this earnings season being particularly strong. But there has been this underlying fear – when is this going to end? When are earnings going to peak? And when Caterpillar essentially said “this is as good as it gets,” that hit a nerve for investors.
Key takeaway. I expect to see continued nervousness going forward, as markets look for signs that earnings have peaked. Focus will of course be on forward guidance provided on earnings calls.
- Growth moderation. The initial reading of U.S. gross domestic product growth for the first quarter was 2.3% annualized,1 a significant decrease from fourth quarter growth. We could be seeing the continuation of a historical pattern in which first quarter growth tends to be weaker than subsequent quarters. However, we are also seeing a moderation in eurozone growth and U.K. growth. In fact, economic growth in the U.K. was at its lowest level in several years, indicating that the British economy is under pressure as the official Brexit date nears.
Key takeaway. Similar to the jitters we saw last week around earnings, I believe markets will become more sensitive to any signs of a moderation in global growth this year, as so much is riding on continued strength. I think that, for most economies, this is only a temporary pause and we will see that strength continue. However, any signs that growth is waning are likely to be met with a negative market reaction.
- The 10-year U.S. Treasury yield breached 3%. This occurred last week.2 And although the 10-year yield subsequently retreated below this level, this was a critical development with a variety of implications (see my previous blog, Yield signs: Deconstructing a key market indicator).
Key takeaway. Markets are becoming more sensitive to developments such as changes in the 10-year U.S. Treasury yield. I expect that to continue going forward, leading to more volatility.
Five things to watch in May
- Heightened sensitivity. As I mentioned above, I believe markets are going to become increasingly sensitive to signs that global growth and/or earnings have peaked, just as they are sensitive to changes in the yield on the 10-year Treasury. So we should expect outsized stock market reactions to economic data, comments from companies and other seemingly minor developments.
- Fed decision. The FOMC will meet this week, and I expect inflation will be on their minds. We have seen a number of different indicators suggest inflation is on the rise, particularly the Fed’s favourite inflation indicator – the core personal consumption expenditures (PCE) price index – which rose to 1.9% in March.3 I believe this will result in the Fed raising rates three more times this year and, more importantly, I wonder if it will cause the FOMC to consider accelerating balance sheet normalization – which could have a far more dramatic market impact than an additional rate hike. We will not only want to scrutinize this week’s announcement (the Fed will likely include an acknowledgment that inflation has come closer to its target) but we will also want to read the minutes of the meeting when they are released for more insight into the FOMC’s thoughts on this issue.
- Tariff decisions.S. President Donald Trump will decide on whether to apply 25% tariffs on steel and aluminum to the European Union – which had heretofore been granted a temporary exemption. This is a critical decision, as it could create a significant headwind for economic growth in the eurozone just as growth has already slowed – we got further confirmation of this from the recent slowdown in broad money (M3) growth. And we can’t forget this could plunge the globe deeper into a state of protectionism. We will want to follow this closely, as the cessation of this exemption could be met with a negative market reaction, at least in Europe.
- Trump will also soon decide on the Iran nuclear accord – his decision is expected by May 12. French President Emmanuel Macron tried to save it with his visit last week to the U.S. and his subsequent outreach to Iran, but even he doubts he was able to save the deal. This could create more uncertainty – and place greater upward pressure on oil prices, as well as downward pressure on the stock market.
- US.-China trade talks. A U.S. trade delegation will meet with Chinese officials in Beijing this week. It appears that China may take a hard line in the negotiations – as of this writing, China has indicated that it will refuse to even entertain the Trump administration’s two most dramatic trade demands (a mandatory cut in the trade deficit between the U.S. and China, and a cap on China’s capital investment in the country’s most advanced technological industries). We will want to follow this closely as the odds seem to be increasing that there may be a bad outcome, which again could take us further down the path of protectionism.
Finally, I want to pay my respects to everyone who was affected by last week’s van attack in Toronto, which claimed the life of one Invesco colleague and injured another. My thoughts and prayers are with the victims, their families and friends.