Senior FX Options Specialist Fred Stambaugh explains how the threats of trade action were the dominant influence on global currency, commodity and equity markets in Q2.
The astounding volatility that seized global markets in the first quarter of 2018 was due in part to rumblings of President Trump’s promised trade war. During Q2, that promise came closer to fruition. And while equity volatility subsided from the February-March period, the threats of trade action were the dominant influence on global currency, commodity, and equity markets.
The main focus — but hardly the only one — was the trading relationship with China. There is general agreement in Washington and even among U.S. allies that China has been accumulating next-generation technologies through abuse of trade rules and outright theft, and Trump’s trade policies are aimed at forcing China to change its policies. After announcing steel and aluminum tariffs in March, Trump raised the ante by proposing tariffs on $50 billion in Chinese goods. Negotiations went back and forth, with truces and escalations, until at quarter’s end Trump affirmed the first $34 billion in goods subject to tariffs, together with sharper restrictions on investment in U.S. technology companies. China vowed to tax its own list of goods, including soybeans, of which it is the U.S.’s largest customer, and the U.S. countered by targeting a further $200 billion in imports.
Trade relations with America’s allies also deteriorated. The tariffs on steel and aluminum that were threatened in March became a reality in June, and previous suggestions of relief for close allies in Europe and Canada were ultimately brushed aside. Trade partners immediately countered with restrictions of their own, aimed specifically at heartland products like agriculture, and niche products like bourbon and Harley-Davidson motorcycles. After the G-7 summit in Quebec broke down over trade issues, with Trump departing without signing the communique, the President doubled down and threatened tariffs on imported autos.
Markets took note. The Dow Jones Industrial Average fell 700 points on March 23, the day Trump first announced the China tariffs, and 400 points after the investment restrictions were announced May 29. U.S. agriculture futures suffered: corn fell by 14% and soybeans by 17 1/2 % in June alone. Emerging markets, which risk being caught up in the winds of a trade war, saw their currencies and their equity markets fall throughout the quarter. In China, the Shanghai stock market lost 8% in June, while the renminbi declined by 3.5% in a straight line from June 14 onward.
The dollar rose almost without pause throughout the term. This was partly due to the dollar’s traditional safe-haven status, and investors fled to the dollar as the trade war loomed; the 10-year bond yield correspondingly declined as investors sought safety. The dollar’s rise was also the market’s reaction to the Federal Reserve’s continued tightening campaign, and accelerated after the June meeting. The Fed raised rates as expected, but also announced that future rate increases would be more front-loaded into 2018 than earlier signaled.
This was in particular contrast to the policy statement from the European Central Bank just a day later, when it announced it would end its bond-purchasing program at the end of the year but would keep ultra-low interest rates on hold through the summer of 2019. The euro fell 1.9% that day, and the 10-year Bund yield over the next two weeks declined from 0.5% to 0.3%.
The Fed announcement underscored the fact that, trade wars notwithstanding, the U.S. economy was enjoying a broad-based expansion. With the regulatory relief and tax reform of 2017, growth accelerated, unemployment fell to multi-decade lows, and inflation started to rise. Business and consumer confidence rose to boom-time levels. U.S. equity markets rose as well, albeit by fits and starts, subject to undertows from the trade debates.
Other developed economies grew, but more modestly. Canada faced the uncertainty of the NAFTA negotiations, while Britain continued to struggle amid internal debates over its strategy in Brexit negotiations with Brussels. Europe, for its part, faced its own internal threats, with a populist election in Italy, separatist agitation in Spain, and most recently a rebellion within Chancellor Merkel’s coalition over immigration policy. Equity markets, currencies, and bond yields generally declined over the quarter.
One notable exception to the general market bearishness was Mexico. While the peso and the Bolsa weakened through May, in anticipation of the election of leftist Andres Miguel Lopez Obrador as president, both markets reversed sharply in June. The peso gained over 4% and the equity market nearly 7.5% in the last days of the quarter as prices adjusted to the near-certainty of AMLO’s election.
Another market bucking the downtrends was crude oil. Continuing a rise that began before OPEC’s production agreement last fall, WTI reached a high of nearly $75 at quarter–end, the highest level since the market collapse of 2014. The communique from OPEC’s June meeting called for a return to 100% compliance from 152% in May, to levels that barely offset the loss of Venezuelan crude and the expectation of renewed sanctions against Iran.
At quarter’s end, the imposition of tariff and counter-tariff is just beginning. There are those who are confident that this is all just a tactic by the Trump administration to wring negotiating concessions; others fear that a worldwide regime of higher tariffs is the intended end-state. The result will depend on actions taken by the contending governments along the way.
In the meantime, victims of tariffs — both exporters losing business and consumers facing higher prices — will likely be more numerous and more evident than the beneficiaries, whose gains are in not losing their jobs or businesses. With the mid-term elections approaching, their stories can be expected to raise political pressure on the president.
Trump is famously stubborn, but the sanctions could hurt his own base and throw the election into doubt. How this will play out is anybody’s guess, and much will depend on the outcome.