The S&P 500 fell 2% last week as two potential dangers to the multi-year rally in risk assets resurfaced. On 27 February new Federal Reserve chairman Jerome Powell delivered his debut testimony to congress, stating that "some headwinds facing the US economy are now tailwinds" and that the central bank is keen to avoid "an overheated economy”. Equities declined as his comments failed to allay concerns about higher US inflation leading to faster Fed tightening. Stocks fell further on 1 March after President Trump announced his intention to impose tariffs of 25% on steel imports and 10% on aluminum.
But in both cases we see reasons why the negative reaction may be overdone.
1. We don’t believe Trump’s tariff announcement significantly alters the positive outlook for global economic growth. Trump's order has not been finalized, and the details will matter. Some countries may be excluded, reducing the impact of the tariffs. Even in their current headline form, the tariffs’ impact on aggregate inflation and demand should be negligible; steel and aluminum account for only 1.6% of US imports and 0.2% of GDP. Retaliation appears probable, but is likely to be targeted at politically sensitive goods, for example specific industries in US swing states. Such measures ahead of US mid-term elections might also prove effective in prompting an easing of the restrictions.
We are monitoring developments, as Trump’s latest trade announcement is unlikely to be his last. Last week’s annual report from the USTR specifically cited Chinese intellectual property violations as a potential subject for future US action. Escalation is a risk, although we see only a 20-30% chance of a full-scale trade war over the next six to 12 months. Our base case remains that Trump imposes one-off tariffs for the benefit of specific industries, and that this will not cause a full-blown international trade conflict.
2. Powell’s testimony is a clear indication that this month’s Fed projections are likely to forecast higher growth and inflation, as well as a higher “dot plot” of interest rate estimates. In our view, higher dots needn't mean faster tightening: in his second day of testimony Powell clarified that he saw few signs of overheating, suggesting that rate hikes will remain gradual.
Fed policy remains data dependent, so the inflation data are more important than the dot plot, and here last week’s figures were reassuring. The year-on-year increase in the core PCE price index, the Fed’s preferred inflation measure, was 1.5% in January, unchanged from December and still comfortably below the Fed’s 2% inflation target. Wage growth is another investor concern, and Powell also saw no strong evidence of a "decisive move up in wages." The Atlanta Fed wage growth tracker is currently running at 3%, but was as high as 3.9% in November.
Overall, we see Powell’s testimony as indicating policy continuity: investors should be reassured that he stressed the gradual nature of the removal of monetary policy accommodation. We are monitoring inflation developments, but at present we believe the Fed is likely to remain on this gradual path, which is unlikely to put significant upward pressure on bond yields or undermine equity markets.
Global Chief Investment Officer WM
Equities suffered two main setbacks last week. First was Fed Chair Jay Powell's debut testimony to congress, which warned of the risks of "an overheated economy." Second, President Trump announced stricter-than-expected tariffs on US steel and aluminum imports. But the tariffs may yet be watered down, and their economic impact should be negligible. Powell later said that signs of overheating have yet to materialize, which was backed up by stable inflation data.
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