Introduction

Markets were turbulent in the second quarter. Escalations in trade tensions weighed on confidence in the global economic expansion. However, stocks proved resilient in June thanks to commentary by the Federal Reserve that was interpreted to indicate that, in the face of slower global growth, it may reduce bank borrowing rates to sustain the economic expansion. Several major central bankers, who are also contending with economic fallout from trade tension, have followed suit with more accommodative rhetoric.

A negative repercussion of this pivot is that central bankers will be left with little room to maneuver the next time their economies actually recede. The U.S. federal funds rate is just 0.25% when adjusted for inflation. At the end of the last tightening cycle in 2006, it was 2.75%. Since the “Great Recession” ended, both the European Central Bank (ECB) and Bank of Japan (BOJ) never managed to raise rates out of negative territory. It is clear they are inadequately prepared to reverse the next recession. When combined with high levels of indebtedness, this should be worrisome, yet the markets are not pricing in these concerns.

Market Update

Negotiations between the U.S. and China seesawed in the second quarter. Hope for a trade resolution climbed in April, only to falter in May. Tensions flared subsequently when the U.S. threatened to impose additional tariffs on a final tranche of $300 billion worth of Chinese imports and also ban U.S. companies from selling electronic components and technology to Huawei, China’s “national champion” in the telecommunications industry. China announced its own set of retaliatory tariffs, and Chinese state media ramped up nationalistic rhetoric against the U.S. At the end of June, parties were able to agree to a temporary truce between President Trump and President Xi, laying the groundwork for bilateral talks to restart.

Similar events occurred with Mexico. In May, President Trump announced new tariffs on imports from Mexico in an effort to reduce the inflow of Central American asylum-seekers to the U.S., and he subsequently reached a deal to avoid tariffs after Mexico committed to stronger countermeasures. The impacts of such tariffs would have been substantial for the U.S., given the deep economic linkages between the U.S. and Mexico. Moreover, new tariffs would have imperiled the ratification of the recent U.S.-Mexico-Canada trade agreement.

Dovish comments by the U.S. Federal Reserve were the key tailwind for the markets, helping offset worries about trade frictions and providing cover for other central banks to turn more accommodative. The Reserve Bank of India (RBI) and Reserve Bank of Australia (RBA) were among central banks that cut rates in the second quarter. Among G10 currency region countries, only Norway’s central bank is firmly in a tightening regime.

Overall, the U.S. economy remained healthy, with unemployment near 50-year lows and inflation expectations remaining stable despite missing the 2% objective. Inflation had picked back up recently, but the increase was less than expected. Nevertheless it’s worth noting that second quarter 2018 economic data, that benefited from inventory building ahead of increased tariffs and a massive reduction in corporate tax rates, will make for a very difficult comparison this year. The Fed kept rates unchanged, but signaled an openness to cut rates if downside risks grew more pronounced. Data that will be released in early August may prove pivotal.