Global markets have reacted negatively to heightened risks over the past few weeks. President Donald Trump's threat to impose tariffs on Mexico has broadened the tariff issue beyond China.
The drag from increased trade tensions is starting to show up in weaker economic data, and markets have now priced in around 100 basis points (bps) of Federal Reserve rate cuts by the end of 2020.
Investors have also been concerned about reports that the US government is going to investigate Google, Facebook, Amazon, and Apple on antitrust grounds.
The odds of a rate cut have clearly risen amid rising trade tensions. However, we believe it would take a recession to provoke a series of rate cuts currently being priced by the market, and the next recession is several months away, in our view.
US unemployment at 3.6% is the lowest in decades, and rising job openings suggest not much slack left in the jobs market.
US economic growth remains fairly steady and financial conditions are accommodating. So far, Fed Chair Powell has indicated that the Fed will respond to future signs of weakness, not that a rate cut is imminent. Chicago Fed President Charles Evans, meanwhile, has said that economic data do not yet point toward the need for a cut.
Given this scenario, we anticipate a melt-up in the equity markets as a reaction to a rate cut by the Powell Fed. The S&P 500 could rise as high as 3100 on such a melt-up. But we don't expect the euphoria to last.
When the Fed cuts rates to defend the economy from a recession, it rarely works out the way investors imagine it will. The Fed doesn't have the tools to prevent a recession. The business cycle will likely prevail over the policy measures initiated by the fed.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in spy over the next 72 hours.