Perhaps the biggest news of the last week was the meeting of the Federal Open Market Committee (FOMC), the policy-making arm of the U.S. Federal Reserve (Fed). As expected, the Fed raised interest rates. But what was far more interesting were the hints provided about the future. In this blog, I discuss my outlook for the Fed and highlight five issues to watch in October.
The Fed changed its statement
The fed funds rate dot plot – in which the FOMC participants share their policy prescription for future rate hikes – did not change. However, the Fed did alter its statement, deleting the sentence, “The stance of monetary policy remains accommodative, thereby supporting strong labour market conditions and a sustained return to 2% inflation.”
At the press conference, Fed Chair Jerome Powell asserted that this change in language does not mean that the policy is no longer accommodative. However, I believe that the reality is different, given that several FOMC participants have noted in previous minutes that the Fed is nearing the point where it can no longer call monetary policy accommodative. My takeaway is that this change suggests a higher hurdle for the Fed in order to raise rates in the future. I believe the Fed remains undecided about a rate hike in December and that the next few months will ultimately dictate whether or not there is a fourth rate hike in 2018.
China shared its views on trade with the U.S.
Also receiving significant attention was China’s release of a white paper last week that became notorious for its perspective that the U.S. is “bullying” China. What I found more compelling were some of the statistics it shared on U.S.-China trade that may not be well-known:
• U.S. exports to China are growing faster than U.S. exports globally.1 In other words, China is an important growth market for the U.S.
• In 2017, U.S. exports to China included 57% of its total soybean exports, 25% of its total Boeing airplane exports, 20% of its total auto exports, 14% of its total integrated circuit exports and 17% of its total cotton exports.2
• In terms of services rather than goods, the U.S. was actually running a significant trade surplus with China as of year-end 2017.2
• Exports to China lifted U.S. gross domestic product growth 0.8% in 2015.3
• Trade with China has helped to significantly lower the inflation level in the U.S. Imports from China lowered U.S. consumer price levels by 1%–1.5% as at Dec. 31, 2017.3
In other words, trade with China has provided some significant benefits to the U.S. that could be lost or diminished if trade tensions continue.
Five things to watch in October
As we look ahead, there are five critical things for investors to watch:
1. RE-NAFTA: Renewal of NAFTA. The U.S. and Canada were able to reach a preliminary deal on the revised North American Free Trade Agreement (NAFTA) with minutes to spare before the deadline. It seems the U.S. ultimately did make some important concessions, and, in exchange, Canada gave the U.S. “more access to the dairy market.” This agreement is relatively similar to the original NAFTA – the most important addition is that it was updated for the 21st century, including intellectual property protections. In my view, the Trump administration had to make this deal work because it was unlikely Congress would approve a bilateral deal. In addition, it was important to have a trade “win” before the U.S. mid-term elections in November.
Markets may react jubilantly for days after this announcement, but we need to remember that the stock market has typically had an asymmetric reaction to trade developments: positive developments have usually caused significant rallies, while negative developments have barely made a dent in stock prices. I believe this will change, as more investors contemplate the consequences of current trade actions. That’s especially so given that the Trump administration has now reached a deal with Canada, which enables it to focus even more of its attention and efforts on China. I expect the situation with China to deteriorate in the coming weeks.
2. The trade war between the U.S. and China. I expect it to heat up from here, and I expect we will begin to see more of an impact in the economic data. In September, the Caixin/Markit Purchasing Managers’ Index (PMI) for China fell to 50.0 – its lowest level since May 2017 – and is now in neutral after showing expansion for 15 months.4 This suggests Chinese manufacturers are already feeling some pain from the burgeoning trade dispute with the U.S. However, the PMI for the services sector rose,4 suggesting domestic demand is growing stronger, which makes sense given that China has been ramping up domestic spending to compensate for any damage done to its export business.
However, the U.S. may also begin experiencing some damage from the trade conflict with China. Moody’s has already forecast that higher American tariffs on Chinese imports could offset some of the gains of the U.S. tax-reform legislation by reducing U.S. gross domestic product (GDP) for 2019 by 0.25%.5 And, Goldman Sachs warned in July that if trade tensions spread and a 10% tariff were imposed on all U.S. imports to China, its earnings per share estimate for 2019 would drop 15%.6
Tariff tensions can also impact the U.S. economy in small ways that add up. For example, Chinese tourism to the U.S. during this week’s National Day holidays (“Golden Week”), while typically robust, is expected to fall significantly – there has been a 42% decrease in flight bookings from China to the U.S. for Golden Week compared with last year’s holiday bookings.7 This is part of a larger recent trend of declining travel bookings from China to the U.S. In my view, pain inflicted on the U.S. as a result of these trade disputes may become more noticeable moving forward while damage done to China will remain quite visible.
3. Trade talks between the U.S. and Japan. U.S. President Donald Trump and Japanese Prime Minister Shinzo Abe agreed last Wednesday to begin trade talks. Apparently, tariffs on Japanese automobiles will be off the table, at least for now. As I mentioned before, Prime Minister Abe has secured a third term, and I expect him to be strong and firm in trade negotiations with the U.S. Somewhat surprisingly, the Japan Tankan survey for the third quarter – a reading of business confidence – clocked in at a low 19 for the third quarter, well below expectations of 22, suggesting Japanese businesses may be worried about the potential for a trade dispute with the U.S.8 We will want to follow the situation closely.
4. Ongoing Brexit negotiations. There is still no deal, and one does not appear to be in sight. Brexit secretary Dominic Raab warned on October 1 that the European Union could force the country into a no-deal Brexit, so attention is turning to what could happen to companies if this comes to pass next March. For example, Toyota’s car plant in Derbyshire announced it would close for an unknown period of time if Britain leaves the EU without a deal.9 We are likely to hear from more companies in the coming weeks as a no-deal Brexit becomes an increasingly likelier possibility.
5. Inflation. There is the potential for higher inflation as a result of tariffs in a variety of countries, but particularly in the U.S., as FOMC participants noted in the minutes of their August meeting. We will want to follow inflation metrics closely for signs of this, as it may force the Fed to raise rates in December – and raising rates to contain inflation caused by tariffs may not be a wise decision for the economy, in my view.