When a cartoon character puts his finger in an electrical socket, he experiences a shock. Usually he jumps several feet in the air and all of his hair stands on end. His whole body lights up and his skeleton becomes visible. An economy experiences a shock when an unexpected outside event significantly affects growth or inflation. Economic shocks can be positive or negative, and they can affect either supply or demand. 1 1 Close They force economists to shift the curves on their charts. Then economists have to find new equilibrium points. It’s an art. An example of a positive shock might be a new technology that allows companies to produce more of a given product or service. Unfortunately, investors are probably more familiar with negative shocks not because they are more common, but because they are more memorable. Droughts, earthquakes, and sudden currency devaluations jolt markets more than unexpected surpluses. These shocks can knock markets out of equilibrium, and markets can be slow to adjust, which is understandable. It isn’t always immediately clear how important an event is, and it is difficult to remove long held positions even when a 50,000-watt surprise hits your portfolio. 2 2 Close
There are no official rules as to what qualifies as an economic shock, but the current trade war meets almost any criteria. The scale and timing of the U.S. tariffs on China were a surprise to most businesses, consumers, and economists. Tariffs affect aggregate supply in the economy because they can make goods more expensive and in some cases scarcer. Since at least some of the costs of tariffs will appear in prices, they can increase inflation. A disruption to supply chains would, almost by definition, be a negative shock to supply. Tariffs can also, paradoxically, create pockets of excess supply. For example, if China buys less of a U.S. product it could result in gluts in the U.S. and vice versa. 3 3 Close For example, if China puts a tariff on lobster, Maine could end up with a glut of lobsters. Talk about shell shock! They can also lead to increased domestic production, which could help demand. While both of these effects are positive, most economists think the other effects outweigh them, and the current tariffs constitute a negative supply shock.
Tariffs have to be large enough to impact the economy as a whole for the shock to be material. Some economists have pointed out that bilateral trade with China is only 3.5% of U.S. GDP. 4 4 Close In 2018, U.S. goods and services trade with China totaled an estimated $737 billion. Exports were $179 billion and imports were $558 billion. U.S. nominal GDP as of Q4 2018 was $20.87 trillion. Sources: United States Trade Representative, Bureau of Economic Analysis. However, tariffs on over $500 billion of products should be enough to move the dial even in a $20 trillion economy. There are just too many items and areas which will be affected. If the trade war escalates, its effects will likely show up in the economic data – there isn’t much controversy about that. The more difficult question is whether the economy can withstand it. In recent years, developed economies have been able to experience what seem like significant supply shocks without generating inflation. They have not always been so lucky on the growth side. There is a general rule of thumb among economists that when GDP falls below 2%, it becomes vulnerable to shocks and can be pushed into recession. Right now U.S. growth is above that level, but that does not mean it is totally safe. 5 5 Close [Source]
In 2018, the U.S. economy exceeded expectations, but this year it may not be as strong as it appears on the surface. Housing activity has been slowing for most of the year. Consumption has been good, but not exceptional, and investment has remained tepid. The Q1 GDP release benefited from an increase in inventories, which is probably temporary. Economists had been forecasting a weaker Q2 number – even before the additional tariffs were announced. The problem is that there isn’t another big stimulus bill in play to match last year’s tax cuts. Some folks had hoped there would be an infrastructure spending plan, but discussions have stalled. State spending increases may provide a boost, but they won’t match what we saw from the federal government last year. Meanwhile, Fed rate hikes are still working their way through the economy. There is often a lag between monetary policy tightening and its drag on the data.
Despite these so-called headwinds, the momentum of the economy is still strong enough to maintain positive growth. There are few signs of an imminent recession, but the economy is not so strong as to be invulnerable. If the trade war isn’t resolved, its fallout could be enough to bring growth to a standstill. This is why markets have been so skittish, in contrast to their indifference toward other political events a few years ago. 6 6 Close Also, the magnitude of the conflict with China. Investors only care when these events have the potential to affect the economy in a material way, and we seem to be at that point.
Investors have also been hopeful for a positive shock to counterbalance the trade war. This week the stock market got a boost from comments from Fed Chair Powell. He kind of sounded like Mario Draghi lite with his statement that the Fed will do what is “appropriate to sustain the expansion.” 7 7 Close Federal Reserve Chair Jerome H. Powell: “Opening Remarks,” at the "Conference on Monetary Policy Strategy, Tools, and Communications Practices" sponsored by the Federal Reserve, Federal Reserve Bank of Chicago, Chicago, Illinois. 6/4/19. It’s not quite as bold as doing whatever it takes to save the euro, but it was enough to lead the S&P 500 to its biggest one-day gain in months. 8 8 Close The S&P 500 index rallied 2.1% on June 4, 2019, the day of Powell’s comments. This was the largest one day increase since January 4, 2019, when the S&P 500 index rallied 3.4%. Source: Bloomberg. A potential Fed cut probably isn’t a true shock. Markets have been pricing monetary policy easing for months now, and a rate cut is not an outside event. In this case, it may be okay to fudge the definition a little. 9 9 Close It may be more evidence of what we argued two weeks ago, that market pricing doesn’t exactly reflect participants’ expectations. After Powell’s comments, markets may be paraphrasing Captain Renault in Casablanca: “I am shocked, shocked to find out that rate cuts are being considered here!” 10 10 Close No relation to the car company that I know of.
If the trade war had occurred when the economy was going at full speed and monetary policy was loose, it probably would have been ignored by markets. The relative vulnerability of the U.S. and for that matter the global economies make it very relevant for current pricing. Now, in addition to trying to figure out earnings and growth, investors have to consider the unpredictable actions of negotiators from both the U.S. and China. Trying to figure that out is just like putting your finger in an electrical socket.
What We Are Watching
China Trade Data (Monday), Industrial Production and Retail Sales (Friday) Chinese economic releases were generally disappointing in April, as data showed slower growth in exports, industrial production, and retail sales. Evidence is accumulating that domestic stimulus efforts have yet to gain traction. Economists and market participants will look to May data to see whether the world’s second-largest economy has continued to lose momentum. Trade talks between the U.S. and China suffered a largely unexpected setback in May, and data may indicate whether this had any immediate impact on Chinese manufacturing and export activity. Another downbeat round of data could lead to weakness in equity markets and commodity prices sensitive to Chinese demand, such as copper.
U.S. CPI (Wednesday) Consumer price inflation has picked up a bit over the last couple of months, but some of the drivers of that rebound reversed in May as the dollar strengthened and oil prices fell. These variables will likely weigh on prices in the coming months. Tariff increases may also be a driver of inflation going forward, although the recent tariffs implemented on $200 billion of Chinese goods began on June 1st and thus are unlikely to have had much effect on the May data. 11 11 Close Reuters: “U.S. begins collecting higher tariffs on Chinese goods arriving by sea,” 6/1/19. Recent communications have suggested that the Federal Reserve has a renewed focus on below-target inflation. As a result, markets may react more to lower-than-expected CPI data, which could increase the odds of rate cuts.
U.S. Retail Sales (Friday) Slower global growth and rising trade tensions appear to be weighing on the U.S. manufacturing production and capital expenditures. However, consumer spending remains by far the largest driver of the U.S. economy and recent spending data has pointed to only modest deceleration. Retail sales figures for May will provide an important update on the health of the U.S. consumer amidst heightened global uncertainty. A strong result would indicate that U.S. households continue to support economic growth and might reduce the odds of near-term easing from the Fed, even as markets have priced multiple rate cuts by the end of this year. Strong data could therefore put downward pressure on U.S. fixed income and might support the U.S. dollar.
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