3 reasons why the U.S. tariff threat is spooking markets

On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Research Analyst Brian Yadao discussed the recent rate cut by the U.S. Federal Reserve (the Fed) and the potential impact of additional U.S. tariffs on Chinese goods.

Fed cuts interest rates by 25 basis points, citing trade tensions and global economic slowdown

As expected, the Fed lowered its benchmark interest rate by 25 basis points on 31 July, yet the immediate market reaction following Chairman Jerome Powell’s press conference was negative. Why? Powell stated that the cut did not mark the beginning of a long series of rate reductions, Ristuben noted - which initially cast some doubt about the likelihood of future cuts.

"The likely reason behind Powell’s remark is that, historically, the Fed only embarks on a series of rate cuts when it strongly believes the U.S. economy is rolling over into a recession - and today’s economy is still on fairly solid footing," Ristuben stated, adding that the central bank did not want to convey a panicked tone.

The Fed chair was able to walk a fine line by casting the rate cut as an insurance cut that would help buffer the economy against trade tensions, waning CEO confidence and a slowdown in global manufacturing activity, he noted. "I believe the Fed wanted to provide a reason for individuals to believe that the current economic expansion can be maintained," Ristuben said, "and the central bank did this by cutting rates." Markets ultimately bounced back the morning after the cut, wiping out most of the previous day’s losses, he noted - that is, until the China-U.S. trade war sharply escalated.

Additional tariffs may weaken U.S. consumer spending, job growth

U.S. President Donald Trump’s 1 Aug. announcement that the U.S. plans to impose a 10% tariff on an additional $300 billion worth of Chinese goods in September roiled markets, with the S&P 500® Index down roughly 3.5% on the week, as of mid-morning Pacific time on 2 Aug. The negative market reaction was likely due to three main reasons, Ristuben said:

1. The expected detrimental impact of additional tariffs on corporate earnings.
2. The potential for additional tariffs to harm consumer spending.
3. The potential for a slowdown in hiring due to the tariffs.

Tariffs weaken corporate earnings because they result in an increase in input costs, he stated, pointing to the negative impact that currently imposed tariffs have already had on U.S. earnings this year. Potentially just as problematic is that the $300 billion worth of Chinese imports targeted by these latest tariffs consists mostly of consumer goods, Ristuben noted. "This means consumer spending, which accounts for approximately 70% of the U.S. economy, may be impacted more," he said.

Even potentially more worrisome, in Ristuben’s opinion, is the impact the tariffs could have on the country’s labor market. "Already, CEOs who have lost confidence in the economic outlook due to the trade war are buying capital goods at a lesser rate," he said, "and typically, the next step they’ll take in situations like this is to cut back on hiring." There’s already been a gear-shift in U.S. employment this year, he said, with monthly job gains dropping from roughly 225,000 per month in 2018 to 175,000 per month so far this year. "This slowdown in jobs was expected - and is currently not a problem," Ristuben stated, "but if we see another downshift, the job market will likely become a growing concern."

Will the Fed cut rates again in September?

The latest tariff threat from the U.S. strongly increases the chances that the Fed will slash borrowing costs again at its September meeting, Ristuben said. "Powell noted in his press conference that one of the reasons for the July rate cut was to offset the potential impacts of trade uncertainty - and now, just days later, the amount of trade uncertainty has risen sharply," he remarked.

The debate among market participants ahead of the Fed’s 17-18 Sept. meeting will likely revolve around whether the central bank will slash borrowing costs by 25 or 50 basis points, Ristuben said. "At Russell Investments, we think that a 25-basis point cut looks more likely right now, but there’s a lot of time - and a lot of new economic data to be released - between now and mid-September," he noted. All things considered, Ristuben and the team of global strategists remain of the viewpoint that the U.S. is not rotating immediately into a recession. "Make no mistake, however - things are getting more and more interesting," he concluded.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.