Midyear Outlook: What a Trade War Could Mean for the Bond Markets, and More

We answer some of today’s most pressing investor questions—from the effect of trade wars with China to our expectations for rising rates and a correction in high yield.

Keep Your Eye on the (Most Important) Ball—Liquidity

Markets can react somewhat capriciously to short-term pressures and surprising or unusual events. Sometimes news seems to matter too much, sometimes not enough. Market volatility in general—particularly the tendency for markets to overreact and then correct—is a reflection of overall levels of liquidity.

That’s why it’s important that investors stay focused on the overriding force at play in this environment: the transition from massive liquidity levels to less-than-ample liquidity. The former was the result of global central banks’ decade-long QE campaigns and low, low rates. Our global transition to the latter has only recently begun, now that the US Federal Reserve is hiking rates and reducing its balance sheet. There is much more to come, with quantitative tightening to begin in Europe too.

The shutting of the liquidity spigot—how fast, how much, how tight—is likely to have a bigger influence on financial markets than it does on most developed markets’ economic growth rates. This shouldn’t be surprising, since financial markets have dramatically outperformed the global economy since QE began nearly 10 years ago. To expect a reversal of this pattern under a quantitative tightening regime is well within reason.

Of course, each region and country will be affected differently by global and domestic pressures. For instance, an escalation of trade tensions will have a dampening effect on the global economy, but with greater hits to those economies where trade is more important. And although the Fed’s influence is designed to most directly impact the US, its second-order impacts on non-US economies and markets are greatest on those that cannot as easily withstand the burden of this changed liquidity environment.

That’s what continues to hold our attention, even as we recognize and assess the many other influences on the market. With that as the backdrop, here are our answers to the questions we’re hearing most often today.

How will a trade war impact the bond markets?

Although President Trump has threatened additional tariffs on all Chinese imports, which would represent more than $500 billion, the direct impact of the tariffs announced thus far will probably be small. For example, we expect the effective US tariff rate on overall imports will rise from 1.4%—the average since 2000—to just over 2%. Other countries, with smaller GDPs and more trade-dependent economies, will experience relatively bigger direct impacts.