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Observation Deck: Trade War Tumult

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SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy. 

Trade war tumult

Paula Solanes, Senior Portfolio Manager

At the beginning of May, it looked like smooth sailing in the international trade arena. Following the Federal Open Market Committee (FOMC) statement, Federal Reserve Chairman Jerome Powell struck an optimistic tone in discussing the situation, and he suggested that trade tensions between China and the US had moderated, thanks to a temporary truce and an encouraging outlook. Unfortunately, that merely proved to be the calm before the storm. Just a few days later, trade tensions resurfaced with an announcement by the US Administration of a 25 percent tariff on $200 billion of Chinese imports, which was an increase of 15 percent. In addition, the Administration announced intentions to implement a 25 percent tariff on an additional $300 billion of goods, this next tranche is yet to be approved.

Not surprisingly, this prompted a global sell-off in equities and a flight to quality in Treasuries. While this latest tranche of tariffs is yet to be formalized and will undergo a public comment period, the markets detest uncertainty as evidenced by a resurgence in volatility. This culminated in a 19-month low in Treasury yields and almost a 40 basis point (bps) tightening in the Financial Conditions Index (FCI) in May.

The most recent tranche of tariffs targets many consumer goods and is likely to reverberate throughout the economy. Digging deeper into the recent trade negotiations talk, while there isn’t a set outcome yet, there are various possible scenarios that could affect the economy going forward. One notable point is that potentially affected parties can apply for an exemption for products. While that is a long process, if the exemption is granted for a certain product, that exemption will apply to all importers. As trade negotiations continue, it is important to acknowledge the rising risks including a contraction to GDP, higher prices affecting real income for consumers, and general tightening of financial conditions.

Moreover, prolonged trade negotiations are likely to propagate the elevated volatility and general risk-off mentality. If this uncertainty negatively affects growth, the Fed may hold off on further rate increases and even consider interest rate cuts. On the other hand, the actual implementation of tariffs on a protracted basis could put upward pressure on prices and drive up inflation. However, this upward pressure would be a function of higher prices on the supply side rather than a demand-led pressure, making it less likely to prompt the Fed to raise rates. It’s all a delicate balance and it behooves investors to follow closely to see how the situation unfolds.

It is not lost on us that retaliation efforts play a role as well. Just a few weeks ago, Chinese President Xi Jinping called on China to “begin a new long march.” This could be a lengthy dispute, but in the near term there are a few milestones that bear watching:

  • On June 17, there is a hearing to discuss the latest $300 billion of tariffs
  • On June 19, China’s first tranche of tariffs goes into effect
  • On June 24, comments are due following the hearings on the US tariffs
  • On June 28 and 29, Presidents Trump and Xi meet at the G20 Summit in Japan
The situation is dynamic, and we continue to monitor the events.

So what does an investor do against this backdrop of trade turmoil and the uncertainty? By and large, we are taking a measured approach to portfolio strategy by maintaining a neutral duration stance relative to benchmarks. We aim to balance relatively attractive yields in the short end (and possibly in the short term) by selectively adding longer-dated securities on a steady basis to anchor our duration targets. In addition, we believe that any volatility incited by trade negotiations may create pricing dislocations that might enhance the overall opportunities for our portfolios.

 
 

Economic Vista: A mixed bag

Steve Johnson, CFA, Senior Portfolio Manager

The 24-hour news cycle makes it hard to ignore the potential risks of a prolonged trade dispute. All eyes are fixated on the negotiations and whether the recently announced tariffs will become reality and for how long. Although market volatility jumped in May, the overall economic data was a mixed bag — some of it good, some of it bad. For the moment, there has not been a material impact on sentiment and growth. Whether this will change remains to be seen.

The good news is that the US job creation machinery keeps humming along. Nonfarm payrolls increased by an impressive 263,000 in April, pushing the unemployment rate down to 3.6 percent, which is the lowest it has been since 1969. Tightening employment conditions also continued to put slight upward pressure on wages, even as the labor participation rate fell nominally to 62.8 percent. Payroll growth was boosted by a substantial increase in local government hiring, though this should not overshadow the robust growth in the private sector.  

While job growth was impressive, manufacturing data was less so. The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers’ Index (PMI) fell to 55.5 in April from 56.1 in March. That was below market expectations and the fourth decline in the past five months. Drops in three of the four largest subcomponents helped push the index to its lowest level since 2017.

All that didn’t seem to bother the consumer much, as evidenced by the jump in the University of Michigan’s consumer sentiment index to 102.4, which is significantly above expectations and at a 15-year high. The positive reading was driven by a substantial increase in the index for consumer expectations, rising to 96.0 from 87.4, which is its highest reading since 2004. However, the survey’s view of current economic conditions was more modest, improving only slightly. 

Inflation expectations also rebounded notably in the report, with expectations for the five- to 10-year measure rising to 2.6 percent. Of course it’s important to note that this preliminary report was released before the announcement that the US would increase tariffs on an array of Chinese goods, which is widely considered to have an inflationary impact. 

The data from durable goods, which is often viewed as an indicator of business investment, was also slightly worrisome, falling 2.1 percent in April. This was not unexpected and comes on the heels of troubles at Boeing. In addition to lower orders for new aircraft, capital goods orders dropped 0.9 percent in April, while the March durable goods were revised downward to a mere 0.3 percent increase.

Industrial production for April also surprised on the downside, falling 0.5 percent. There was broad-based weakness, including a notable 2.6 percent drop in machinery production. This is the largest decline since 2014 and not a particularly encouraging sign for future capital expenditures. Production of computers and electronic products, electrical equipment/appliances and components, and motor vehicles were all weaker. Outside of manufacturing, mining output rose 1.6 percent, breaking a string of three consecutive monthly declines. With softer industrial production in April, total industrial capacity utilization fell to 77.9 percent, which is a new low since February of 2018. 

Ultimately, the recent data looks mixed. Perhaps that reflects some uncertainty in the status of trade negotiations. For the moment, growth does not seem to have been affected much. Real gross domestic product (GDP) increased at an annual rate of 3.1 percent in the first quarter of 2019, according to the second estimate released by the Bureau of Economic Analysis. Of course, GDP is a lagging indicator, and all eyes are watching if prolonged trade disputes will disrupt supply chains and global trade. Stay tuned.

Credit Vista: Retailers brace for impact

Daeyoung Choi, CFA, Credit Research Analyst

On May 10, the Trump administration increased tariffs on $200 billion worth of Chinese imports to 25 percent, up from the 10 percent rate that had been in place since September 24 of last year. The list of items subjected to tariffs is expansive and includes everything from chemicals, cardboard and floor tiles to appliances, consumer electronics and clothes. As it has been widely reported, the bulk of the impact from the tariffs will be borne by US importers and retailers and, to the extent they result in higher prices, US consumers as well. To date, there has been little evidence that Chinese manufacturers have lowered their prices in response to the tariffs.

Large US retailers, for their part, are preparing to adapt and respond to what remains an extremely fluid situation. As a number of major retailers reported their quarterly financial results over the past few weeks, the executives fielding analysts’ questions revealed how they are preparing for the intensifying trade dispute with China and higher tariffs. Home Depot, for example, revealed that the total cost of the tariffs in 2018 has been approximately $1 billion, and it was expecting to take another “$1 billion incremental” hit as a result of the recent increase to 25 percent. Nevertheless, management remained constructive as they noted “$1 billion is less than one percent of total sales” for the company and expressed confidence that the tariffs are “manageable.”

Target noted that in 2018 tariffs have had a “minimal impact.” In light of the higher tariff rate, Target’s management team is in the process of developing “contingency plans to help mitigate the impact of tariffs,” including working with a range of vendors that “have been diversifying their manufacturing base” and making “surgical decisions to invest in inventory” in certain categories, such as toys and baby products. Some price increase will likely be inevitable, however, and management expressed concerns that tariffs will “lead to higher prices on the everyday products for American families.”

Walmart is also working on developing “mitigation strategies” and stressed that it “continuously” looks for “best costs around the world.” The company is also holding onto more inventory, reporting an increase of 5.9 percent during the first three months of 2019. Like Target, Walmart conceded that eventually “increased tariffs will lead to increased prices.”

The ultimate impact to the US retail sector is unclear, as nobody knows how the situation will resolve. As none of the above retailers have yet incorporated the impact of the 25 percent tariffs into their full-year guidance for 2019, some changes in financial outlook may be on the way. For now, retailers are monitoring the developments and doing what they can to lessen the impact for their customers, even if it means a short-term contraction of their profit margins.

Trading Vista: How low will they go?

Hiroshi Ikemoto, Fixed Income Trader

With trade talks between the US and China stalling and the uncertainty surrounding Britain’s next prime minister, benchmark yields have been grinding lower. The 2-year Treasury yield has lost 38 basis points (bps) since the beginning of May and hovering at a rate not seen since December of 2017, as of the end of May. In fact, all parts of the Treasury curve have rallied, and the inversion between 3-month T-bills and 10-year Treasuries stands at roughly 21 bps. We are also seeing yields falling in the Treasury bill market, thanks to diminishing supply as the Treasury department has been reducing the size of their bill issuances. Fed funds futures, which represent the market’s view of where rates are headed, are projecting a 75 percent chance for a rate cut in September, and the forward rate for the end of 2019 is projecting at 1.86 percent.

In the corporate bond market, the Eurodollar Synthetic Forward (EDSF) curve, which is used to price corporate bonds maturing inside 13 months, has rallied on the longer end by 28 bps and is also inverted. Spreads have softened by roughly 10 bps, but with the rally in benchmark yields, all-in yields are lower than they have been in previous months. Issuers of commercial paper have been mostly on the sidelines in May, as corporate funding needs seem to have been fulfilled near term. As a result, money market yields have been hovering around 2.38 percent across the curve.

With interest rates dropping and the market predicting a higher chance of a rate cut this year, we continue our strategy of keeping our portfolios at a neutral duration and selectively investing in longer end securities to hedge against further rallies in the market.

Markets

Treasury Rates: Total Returns:
3-Month 2.34% ML 3-Month Treasury 0.23%
6-Month 2.35% ML 6-Month Treasury 0.24%
1-Year 2.20% ML 12-Month Treasury 0.31%
2-Year 1.92% S&P 500 -5.65%
3-Year 1.87% Nasdaq -7.26%
5-Year 1.91%    
7-Year 2.02%    
10-Year 2.13%    

Source: Bloomberg, Silicon Valley Bank as of 5/31/19

0619-0035MS-053120

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. Views expressed are as of the date of these articles and subject to change. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. This information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction.

None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of SVB Asset Management.

SVB Asset Management is a registered investment advisor and nonbank affiliate of Silicon Valley Bank, and member of SVB Financial Group.

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About the Author

Paula Solanes is a senior portfolio manager at SVB Asset Management (SAM) based in the San Francisco Bay Area, where she manages investment strategies in fixed income securities for her clients. With more than 10 years at SVB, including more than seven years in her current position, Paula’s specialty is balancing opportunity and risk while customizing portfolios based on each client’s unique situation. Because her role is markedly client-centered, Paula finds it especially gratifying to serve companies in the innovation economy whose goals include making tremendous contributions to our world. She enjoys meeting with each client to review their portfolios and articulate current financial strategies within today’s dynamic economic environment.

Before joining SVB, Paula analyzed financial reports for hospitals at Toyon Associates in Concord, California. Paula holds a master’s degree in business administration from the University of California, Davis, and a bachelor’s degree in business economics from the University of California, Santa Barbara.

Born in Argentina, Paula was raised in New York and Chile. She now lives in Marin County with her husband, their two children and a friendly Springer Spaniel. Paula enjoys yoga, hiking and spending time with her family and friends. She also loves to travel the globe. She feels lucky to live in the Bay Area, which is so rich in diversity.
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