Positives of Tax Reform Outweighing Negatives from Tariffs

Last Week: Interest rates were mixed while global equities rose despite elevated trade tensions. While the trade picture hasn’t improved, hopes for renewed talks between the US and China supported a new “risk-on” sentiment. The yield on the US 10-year Treasury note rose 2 basis points from a week ago, while 1-month LIBOR fell to 2.0732% from 2.0862% over the same period. Oil declined $4 compared with the same time last Friday as Libya resumed production. The US Dollar strengthened, and Gold weakened. Treasury yield volatility, as measured by the Chicago Board Options Exchange Treasury Volatility Index (TYVIX), fell to 3.63 from 3.71 last week, off its weekly high of 3.86.

Inflation ticked higher in June. As evidenced in scheduled data releases last week, consumer prices rose at their fastest pace in six years last month, rising 2.9% year over year while producer prices rose 3.4% over the same period. Despite the rise, the underlying inflation dynamic is still muted, and the data won’t cause the Fed to hike rates more quickly than what markets anticipate: two more hikes this year and two or three hikes in 2019. The data reaffirmed our view that we’ll see two more, 0.25% hikes this year, the next in September, and the last in December-ish. As we’ve stated many times before, until the consumer sees consistent, sustained increases in prices, the Fed won’t waiver from its slow and steady path of rate hikes.

While economists are spooked by trade tensions, most dismiss the possibility of any near-term recession. The National Association of Business Economists surveys its members quarterly. Most shifts in expectations tend to be mild. For instance, the group downgraded its June real 2018 GDP forecast to 2.8% from 2.9% in March. The one data point from the recent survey that stood out was the shift in the balance of risks to growth through 2019. In March, 75% of respondents saw upside, thanks in large part to the growth boost from tax reform and fiscal stimulus. Now, 57% see growth risks skewed to the downside on the back of surging trade tensions. Also evidenced in the survey, few see any risk of recession until late 2019 or early 2020 however.

US preparing another round of China tariffs. Days after trade tariffs on $34 billion in Chinese imports came into effect and China retaliated with tariffs on the same amount of US goods, the Trump administration announced preparations to levy duties on an additional $200 billion in Chinese goods. Given that the process is expected to take several months to unfold, allowing time for negotiations, Treasury yields eased off their recent lows and equity markets rallied. Is Trump’s bluff working? Perhaps, as Chinese media is taking an increasingly measured tone toward the escalating US trade actions, as the Chinese government hopes to reduce the risk of a anti-US backlash hurting the Chinese operations of US multinationals and resulting in subsequent job and revenue losses.

You don’t really need that Tesla: The US will be top the oil producer next year. The United States will be the world’s largest oil producer by 2019 according to a forecast by the US Energy Information Administration. The EIA projects that the US will produce an average of 11.8 million barrels of crude a day next year, surpassing both Saudi Arabia and Russia. US production in June averaged 10.9 million barrels a day. The US last led the world in oil output in 1974.

What to Watch This Week: It’s a busy week of mostly second-tier data, and one notable event worthy of your attention.

On the data front, the week’s release of retail sales, industrial production, housing starts, and business inventories data will primarily serve to solidify estimates of Q2 US GDP growth, while data on regional purchasing manager surveys and homebuilder sentiment for July will provide some of the earliest glimpses into the drumbeat of economic activity for Q3. Overall, we expect growth to slow from 3.9% in Q2 to 2.7% in Q3, as the economy simmers down to a more sustainable growth pace after recovering from a dismal Q1.

The event focus for the week will be Fed Chair Powell’s semiannual testimony before Congress. We expect the testimony to be a sleeper and for Powell to reiterate the Fed’s plans for a slow and steady path of rate hikes, while sounding upbeat on the economy and expressing caution regarding the ongoing trade tensions. We’ll be on guard however, for any remarks about his conviction to hiking rates in December, especially since it risks inverting the yield curve. Any hint of hesitation on Powell’s part would cause us to ditch our expectation for a December hike.

Take-Away: Whether the current trade spat evolves into a true trade war or fizzles into a whimper remains to be seen. One thing is for sure: it will certainly dim America’s economic prospects if it undermines consumer and business confidence to the point where it causes delay in making purchases, hiring or making capital investments. While scary and certainly unpredictable, it isn’t going to happen and will have negligible impact on America’s economic prospects at the end of the day. Why? The powers-that -be know that everyone loses in a trade war.

Given that America’s current positive growth trajectory is partially due to the good vibes derived from last year’s tax-reforms, in order to slow things down, the trade spat will have to meet them with equal measure. For now, that looks like a stretch, as the economic drag from tariffs is considerably smaller than the tax reform-driven propellant. For that reason, the economy is well positioned to remain on a firm, above-trend trajectory, and the Fed will stick to its plan to hike twice more this year.

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