Key Market/Economic Observations

United States
Renewed U.S./China Trade Tensions Overshadow Encouraging First-Quarter Earnings Season

After months of generally optimistic headlines regarding U.S.-China trade relations, tensions reignited early in May after China reportedly reconsidered key portions of the trade agreement. The breakdown in negotiations resulted in the United States raising tariffs on $200 billion in Chinese goods from 10% to 25% and China retaliating with additional tariffs on $60 billion of U.S. goods.

While we believe both sides have clear incentives to reach an agreement, we expect financial markets to remain sensitive to negative headlines, as sentiment had likely become complacent amid the lull in volatility to start 2019. On a more positive note, U.S. markets wrapped up an encouraging first-quarter earnings season, with S&P 500® profits outpacing consensus expectations by 5.2% due primarily to upside surprises from the Consumer Discretionary, Financials, and Industrials sectors.

International Developed Markets
While Pockets of Optimism Remain, International Developed Markets Continue to Grapple with Headline Macro Concerns

A deteriorating Brexit outlook, global trade tensions, political uncertainty, wider Italian debt spreads, and French protests continue to cloud the economic outlook despite a few emerging bright spots. Alongside downward growth revisions from the International Monetary Fund and the European Central Bank, the European Commission cut the Eurozone 2019 GDP estimate from 1.3% to 1.2%. However, the commission also anticipates an improvement in 2020 along with a pickup in activity outside the European Union, including an easing in financial conditions and policy stimulus in some emerging market (EM) economies.

Emerging Markets
Huawei or the Highway — U.S./China Trade Talks Hit a Speed Bump

On Sunday, May 5, President Donald Trump tweeted plans to raise tariffs on Chinese goods, and the MSCI EM Index has declined more than 8% as of May 24. In our view, investors were surprised by the announcement of higher tariffs instead of finding a near-term resolution on trade negotiations. Should global equity market pricing stay at current levels, it would be the worst month for EM equities in nearly four years.

Trade Tensions Weigh on Commodities

Commodities are poised to fall for a third consecutive month after falling in late May, likely due to trade tensions and concerns about slowing growth. Crude oil was the most notable decliner, falling more than 7% in May, with anxiety over trade tensions taking precedence over underlying geopolitical and supply risks. However, we believe lower prices may give the OPEC cover to extend production cuts beyond June. Industrial metals also declined on demand concerns emanating from the escalation in trade tensions. Agricultural commodities saw a brief reprieve from recent weakness, rising more than 1%, with U.S. Department of Agriculture data showing world corn and wheat inventories were lower than expected. Ultimately, the recent weakness in commodities suggests that inflationary pressures are likely to remain subdued in 2019, a benefit to the U.S. consumer and an indication to us that monetary policy is unlikely to further tighten.

Strategy Views
Rising Trade Tensions Bring New Focus on Currency Markets

The escalating trade tensions over the past month between the United States and China have again become the dominant theme moving markets. While weak performance across both U.S. and Chinese equities has garnered most of the attention, we believe the more acute risk to financial markets is currency related — specifically, whether China will materially devalue its currency to counterbalance the impact of rising U.S. tariffs or support the yuan by drawing down reserves and limiting monetary support. Currently, a sharply weaker yuan and its negative secondary effects on other EM economies remain significant risks to global growth. While our base case reflects a stabilization over the near term, we believe the recent EM equity weakness has begun to reflect this fear. This month, we examine the potential impact of a weaker yuan on China and its EM peers, as well as the relationship with the dollar. Further, we detail our rationale for believing a sharp devaluation remains an unlikely scenario.

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