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ECONOMIC FLASH – US-China Tensions Taking a Toll

June 2019

US Economy: Partly sunny.

While consumer confidence and labor market strength continue to indicate an expanding US economy, other data is painting a less rosy picture: Home prices rose in May at the slowest pace in 7 years; inflation expectations fell to the lowest level since mid-2017; and the manufacturing outlook dropped to levels not seen since 2016.

US Stocks: Evaporating gains.

US stocks did an about face as optimism over a resolution to the trade war waned, with both China and the US digging in their heels with new tariffs and the targeting of specific companies for retaliatory measures. US-focused and defensive sectors such as utilities (-0.8%) outperformed.

Foreign Stocks: EM struggle.

Relative to US equities, foreign stocks were mixed with developed markets well outperforming emerging markets (EM). China (-13.1%), owing to its vulnerability to an ongoing trade war with the US and signs of economic weakness that belie the official government estimates, drove the EM decline.

Fixed Income: Bond boost.

The yield on 10-year US Treasuries fell from 2.5% to roughly 2.2% as investors piled into government bonds in a flight to safety. Short-maturity Treasuries now yield more than longer-maturity issues, an “inversion,” which historically has preceded recessions, although not imminently.

Real Assets: Good diversifiers.

Real assets generally provided good diversification to portfolios in May, falling less than equity markets and with less volatility. Notably, a sharp upswing in oil inventories and sliding global demand left the price of Brent Crude oil around $64/barrel, off its year-to-date high.

Alternatives: Hedge funds mixed.

Hedge fund indexes fell less in May than the overall US equity market. As such, long-biased long-short equity funds underperformed their less-exposed, equity market-neutral cousins. Managed futures had trouble with the late-May commodity and equity market declines, which saw recent trends reverse.

Equities Total Return

U.S. Large Cap (6.4%) 10.7% 6.3%
U.S. Small Cap (7.8%) 9.2% (3.6%)
U.S. Growth (6.4%) 13.5% 9.2%
U.S. Value (6.5%) 8.3% 1.5%
Int’l Developed (4.8%) 7.6% (7.9%)
Emerging Markets (7.3%) 4.1% (11.9%)

Fixed Income Total Return

U.S. Agg. Bond 1.8% 4.8% 7.2%
TIPS 1.7% 5.2% 4.8%
U.S. High Yield (1.3%) 7.5% 5.4%
Int’l Developed 1.7% 2.2% (0.6%)
Emerging Markets (0.1%) 2.0% (0.8%)
Intermediate Munis 1.1% 3.3% 6.1%
Munis Broad Mkt 1.5% 4.9% 7.6%

Non-Traditional Assets Total Return

Commodities (3.4%) 2.3% (11.1%)
REITs 0.6% 17.7% 20.3%
Infrastructure (1.3%) 13.9% 6.5%
Hedge Funds
Absolute Return 0.1% 0.9% 0.0%
Overall HF Market (1.0%) 2.2% (3.8%)
Managed Futures (2.3%) 2.2% (1.0%)

Economic Indicators

MAY-19 OCT-18 MAY-18
Equity Volatility 18.7 18.1 15.4
Implied Inflation 1.7% 2.0% 2.1%
Gold Spot $/OZ $1305 $1223 $1299
Oil ($/BBL) $64 $59 $78
U.S. Dollar Index 92.6 91.7 88.7

Glossary of Indices

Our Take

The US Treasury bond yield curve is making headlines again, as short-term yields are higher than longer-term ones. Yield inversion is not normal and has typically preceded a recession, yet the timing of said recession could be fairly far out. On average, a recession tends to occur more than a year after the yield curve inverts. Based on what we’re seeing, the US economy still has room to run. While economic data has been mixed (and has been for several years), a strong US labor market and generally healthy consumer spending continue to give us confidence in the near term. And lower long-term interest rates could revive the cooling real estate market, providing a boost to GDP.

Last month, we highlighted that our biggest near-term concern was a collapse in trade talks between China and the US. While talks continue, investors have grown skeptical of a positive outcome and are pricing in greater fallout for corporate profitability and earnings growth. We believe the stability of China’s economy and relationship with the US will remain the most important drivers of the financial markets as we move forward.

The recent market downturn did not take us totally by surprise, since we had recommended some risk-reduction months ago, due to the downside risks of the trade talks and relatively high valuations. At this point, we remain positive about the outlook for equities by the end of 2019. In particular, our foreign stock allocations may be poised for a rebound after being disproportionately impacted by trade tensions and the US dollar reaching its highest level since 2002.