Trade Anxiety Is Heightening The Risk Of A Recession

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by: Russell Investments
Summary

Markets were hit by a string of negative news the week of May 27, Eitelman said, dragging the S&P 500 Index down roughly 2.2% on the week, as of mid-morning Pacific time on May 31.

Adding to the growing list of concerns, China recently threatened to restrict exports of rare earth minerals to the U.S., Eitelman noted - a move which could be potentially damaging to the U.S. tech sector.

European stocks were also battered the week of May 27, he said, with the STOXX® Europe 600 Index declining approximately 1.8% on the week.

On the latest edition of Market Week in Review, Senior Investment Strategist Paul Eitelman and Head of AIS Business Solutions Sophie Antal Gilbert discussed recent volatility in equity markets, slumping bond yields and the U.S. recession outlook.

Markets sink as Trump announces tariffs on imports from Mexico

Markets were hit by a string of negative news the week of May 27, Eitelman said, dragging the S&P 500® Index down roughly 2.2% on the week, as of mid-morning Pacific time on May 31. First, official Chinese manufacturing Purchasing Managers' Index® (PMI) readings for May showed a slowdown in manufacturing activity, he said, leading to modest concern among markets. U.S. President Donald Trump's announcement that the U.S. will begin imposing tariffs on all imports from Mexico in June then further spooked investors, Eitelman said, especially since Mexico is the second-largest import market for the U.S. after China. "This development is particularly concerning for markets," Eitelman stated, "because the U.S. is now potentially imposing tariffs on two of its largest trading partners."

This move by the U.S. administration will likely only further shake confidence among CEOs and other corporate leaders, he said, noting that business confidence levels in the U.S. have already plunged since the fourth quarter of last year. Adding to the growing list of concerns, China recently threatened to restrict exports of rare earth minerals to the U.S., Eitelman noted - a move which could be potentially damaging to the U.S. tech sector.

European stocks were also battered the week of May 27, he said, with the STOXX® Europe 600 Index declining approximately 1.8% on the week. "While the catalyst for the dip in European markets was slightly different than in the U.S., the root cause was the same: worries over business confidence levels and the region's economic trajectory," he said. German consumer confidence levels, as measured by the GfK Consumer Confidence Index, fell below consensus expectations, Eitelman explained, while the China-U.S. trade war also weighed on the region. In addition, probabilities of a hard Brexit have risen slightly in the wake of UK Prime Minister Theresa May's announcement that she will step down on June 7, he added.

The yield curve re-inverts: What message is the bond market sending the Fed?

Turning to fixed income, Eitelman said that bond yields tumbled the week of May 27, with the yield on the U.S. 10-year Treasury note dropping to approximately 2.15% as of mid-morning Pacific time on May 31. "Yields have fallen by nearly 15 basis points in the past week alone," he said, "with the 10-year Treasury yield now at its lowest level in over a year."

The U.S. Treasury yield curve is now quite inverted, he said, with the 10-year yield significantly below the current U.S. Federal Reserve (the Fed) Funds policy rate of 2.4%. The downward move is reflective of an increased appetite for risk aversion, Eitelman said, due to escalating trade-war tensions and souring economic data. "The market is sending a message that the Fed is going to need to cut interest rates - but it's important to realize that the central bank only typically does so around major turning points in the business cycle," he stated.

Recession risks tick up as trade uncertainty rises

Addressing Gilbert's observation that an inverted yield curve is historically the most reliable predictor of U.S. recessions, Eitelman said that the risks of a recession appear to have increased slightly in the past week. "At Russell Investments, our Business Cycle Index model is now indicating close to a 35% probability of a recession in 12 months," he said, explaining that the probability stood at slightly under 30% in April.

It's important to understand, however, that markets are moving in a risk-averse direction due in large part to uncertainties around trade policy, Eitelman said. "It's not immediately obvious if these tensions and risks will remain in place over the next year or so, especially since an argument could be made that the current U.S. administration would want to resolve these disputes ahead of the 2020 election, in order to have a strong economy in place," he said. If the risks and uncertainty around trade dissipate, Eitelman expects the yield curve to un-invert.

"All things considered, there's a lot of unusual circumstances driving the anxiety in markets today," he said. Ultimately, for Eitelman and the team of Russell Investments strategists to become truly worried about a recession, the Fed would need to enact and maintain a restrictive monetary policy stance. "This doesn't appear to be the case right now," he said, "as what's going on is more of a reaction to external risk factors than to standard macro-economic drivers." While there's no shortage of uncertainty in markets, Eitelman and the team don't see the need yet to dramatically shift allocations in a risk-averse direction.

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