In only the last three weeks or so, we have seen a head spinning progression of different narratives driving markets. Oh how I yearn for the anchor of the Three Phases Model now, but sadly its time has passed. For today’s post, I’m going to briefly cover a range of topics which span various themes. They may sound disjointed, but frankly, the market has been forced to lurch from theme to theme as monumental policy decisions are made, second-guessed, and occasionally rescinded by seemingly inscrutable human beings. The situations are frustratingly hard to analyze, but I offer some thoughts here nonetheless. This is not a commentary on whether the goals of the Trump foreign policy are potentially helpful to the long-run prosperity and security of the United States, but rather I’m trying to address the impact of a binary change in the short-term outlook for growth and financial asset prices.

By the time this note is published, I think it will be obvious, but the breakdown in US-China trade negotiations has abruptly taken over as the most important theme driving markets. If the global economy proceeds through the rest of the year with the most recent bi-lateral tariff hikes in place, those tariffs should be a material headwind to growth. A headwind, it should be noted, which was priced with only a miniscule chance of happening prior to Trump’s tweets on Sunday, May 5th, and which markets are still having a hard time accepting. So while the narrative of “trade war themes aren’t going away – just get used to it,” is an encouraging idea for those looking for risk market upside, the actual tariffs and lingering uncertainty are quite likely to genuinely impact growth precisely at a time when high valuations were built on green shoots of improving global growth in 2H 2019. Though of course, there is still a possibility that a “deal” will happen around the G-20 in late June, risk premiums ought to be wider now because the downside economic risk with persistent (or even higher) tariffs is significant. Global recession probabilities will need to rise.

Another consequence of the tariff hikes and postponed trade agreement is the sudden de-emphasis of the inflation data in the US as it relates to the likely monetary policy pathway. Fed Vice Chair Richard Clarida constructed a narrative ahead of the May 1st FOMC meeting that advocated for “insurance cuts” in the policy rate because inflation was persistently missing the 2% target. I had a blog mostly fleshed out in my head about whether more inflation was a good and desirable thing for the health of the economy or an absurdly inappropriate cost of living increase which would impact families inversely proportionate to their incomes. And then at the press conference, Chair Powell steadfastly refused to take the bait on the idea of “insurance cuts.” In fact the word “cut” was uttered eight times during the press conference, and all eight were journalists trying to trap him. In the days that followed, Clarida and others walked back the insurance cut idea, but then the whole thing was rendered moot by the breakdown in trade negotiations. From here, the future policy pathway is dependent instead on the trade war impact on global growth, and on the Fed’s response to foreign central bank monetary easing. Even if the US continues its record of exceptionalism versus other developed economies (quite likely in my view), the Fed would follow suit in leaning dovish into trade-related headwinds.

But what about inflation? Don’t tariffs raise prices? Well yes, that’s the whole point. But, much like a large energy price spike or consumption tax increase, this sort of inflation is not desirable, is generally considered a one-time spike, and the Fed would probably ignore it as a reason not to cut rates. In fact, tweets like the following illustrate the extent to which the Fed may be boxed-in by trade-related growth headwinds:

“China will be pumping money into their system and probably reducing interest rates, as always, in order to make up for the business they are, and will be, losing. If the Federal Reserve ever did a “match,” it would be game over, we win! In any event, China wants a deal!”

— Donald J. Trump (@realDonaldTrump) May 14, 2019

The president can pressure the Fed, but also the economic realities would probably justify a cut, so the Fed may struggle to distance themselves from the appearance of political interference. Additionally, the perceived ability of each country to respond as needed with monetary and fiscal stimulus is hardening their respective bargaining positions, and in my view reduces the chance of a resurrected comprehensive deal.

The upshot is that while risk assets may continue to experience bear market rallies, especially in the US where exceptionalism may even intensify, valuations need to adjust in aggregate to account for the material change in outlook for global growth in the past two weeks (purely due to human decision-making). As long as global growth concerns are still developing, interest rates should trend lower in yield regardless of whether markets expect central banks to respond dovishly, or central banks fail to see the need to respond, or in the extreme, if any response is ineffectual. Additionally, while the rapid reduction in US dollar liquidity I discussed two months ago did not, itself, trigger a risk-off move, the reserve drain did accelerate as planned and liquidity remains somewhat tight, which can exacerbate downside price action. One last comment on the dollar: it’s a countercyclical currency, especially when accompanied by US exceptionalism, so expect it to remain strong while the trade war narrative dominates and foreign central banks make the first dovish moves.