A woman carries a red umbrella while walking along Wall Street near the New York Stock Exchange (NYSE) in New York, U.S. (Photographer: Michael Nagle/Bloomberg)

Goldilocks Has Abandoned Stock Markets

(Bloomberg Opinion) -- Strong U.S. economic growth has encouraged the Trump administration to escalate the trade war with China, putting increasing pressure on that nation’s economy and financial markets. At the same time, the Federal Reserve raised interest rates last month for the eighth time since December 2015, and a majority of policy makers even see the need to boost rates above the long-run neutral rate.

The prospect of higher tariffs has led several industrial companies including Sealed Air Corp, a maker of packages, and Fastenal Co., which sells factory-floor and construction site basics ranging from nuts and bolts to welding equipment, to forecast reduced profitability as their margins get squeezed. On the consumer front, retail sales rose by only 0.1 percent last month, below the 0.6 percent increase that had been forecast. Mortgage applications have fallen sharply in response to higher borrowing costs.

The recent data points carry a message for investors: Robust corporate earnings growth that has supported elevated equity prices may be coming to an end. Investor disappointment in equities could push them to seek shelter in safer fixed-income securities.

Signs of a slowdown in housing may have the most impact on growth and markets. The increase in the federal funds rate to between 2 percent and 2.25 percent has been accompanied by a rise in mortgage rates and a 7.1 percent drop in mortgage applications during the week ended Oct. 12. Consumer spending accounts for two-thirds of gross domestic product, and housing demand has historically been a major factor in determining the pace of economic growth.

Goldilocks Has Abandoned Stock Markets

Retail sales in September were affected by a 1.8 percent decline in spending at restaurants and drinking establishments, the most since 2016. This may signal that consumers are cutting back on discretionary spending due to the higher rates. When the Trump tariffs are implemented fully during the coming months, prices of basic consumer items imported from China and sold at establishments such as Walmart Inc. could rise, further crimping demand.

As the impact filtered through to markets, the Dow Jones Industrial Average fell from this month’s intraday high of 26,952 on Oct. 3 to a low of 24,900 on Oct. 11. The S&P 500 Index had its worst October start in a decade. Any retaliation to a White House decision last week to pull the U.S. out of a 144-year old postal treaty that subsidized Chinese shippers to the U.S. could further depress stocks.

Goldilocks Has Abandoned Stock Markets

If that wasn’t worrying enough, the Fed has indicated that it will raise its target for the fed funds rate for the fourth time this year at its next meeting on Dec. 18 and 19, with more rate increases to follow in 2019. The rate increases are occurring even as the Fed tightens policy monetary by reducing the central bank’s balance sheet assets.

Although the yield on the benchmark 10-year Treasury note has risen from about 2.81 percent in late August to as high as 3.26 percent, it has since fallen back to about 3.20 percent amid the global uncertainty and signs of tame inflation, defying warnings by analysts that the yield would quickly move up to the 3.50 percent area. Investor caution was further evidenced by the continued narrow spread between two-and 10-year Treasury yields, a historical sign a looming economic slowdown. Should the spread, currently at 0.28 percentage point, go negative following further rate increases, a recession is likely to follow about a year later.

Goldilocks Has Abandoned Stock Markets

Since China imports far less from the U.S. than the U.S. imports from China, a weakening yuan has been the principal adjustment mechanism for the Chinese economy. Despite the Trump administration decision last week not to name China as a currency manipulator, the currency weakened to 6.93 per dollar on Friday, just below the recent high of 6.96 in January 2017. As the yuan eventually trades past 7 per dollar, expect currency weakness to more than offset the impact of higher U.S. tariffs as Chinese products compete for U.S. markets.

Goldilocks Has Abandoned Stock Markets

Chinese GDP growth slowed in the third quarter, and industrial production rose less than forecast in September. The slowdown will be felt further in Chinese equity prices, which have fallen into a bear market by dropping more than 20 percent in 2018. That, and reduced imports from the U.S., would cast a shadow on U.S. equities.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Komal Sri-Kumar is the president and founder of Sri-Kumar Global Strategies, and the former chief global strategist of Trust Company of the West.

©2018 Bloomberg L.P.