Stormy Nafta Talks May Set U.S. Markets’ Future
Date: Monday, January 22, 2018
Markets opened the year with two conflicting sets of influences. On the positive side, equities surged on the expectation that the stimulus from the tax plan will propel corporate earnings and the overall economy. The Dow Jones Industrial Average rose by 4.4 percent in the first two weeks of the year.
At the same time, the yield on 10-year Treasury notes, though up from 2.41 percent at the end of 2017, backed off from their highs of almost 2.60 percent on Jan. 10. And the spread between two- and 10-year Treasury yields fell below 49 basis points on Jan. 5, the narrowest since Oct. 16, 2007, and still remained narrow at the end of the week at below 55 basis points (chart below). Simply put, bond investors are more skeptical about the reflation story than investors in equities.
Amid these contradictory indicators, it is the caution seen in Treasury securities that investors should take more seriously based on this market’s better record in forecasting the economy. It is important to note, as well, that the 10-year Treasury yield has failed to return to the 2017 high of 2.63 percent set in March despite two global developments that should have pushed it upward.
First, the Bank of Japan decided on Jan. 9 to reduce purchases of government bonds maturing within 10–25 years, and in 25–40 years, by 10 billion yen ($90 million) each. Some investors took the announcement to suggest that the BOJ had joined other global central banks in tightening liquidity.
Second, senior Chinese officials responsible for deploying the country’s $3.1 trillion in foreign exchange holdings told Bloomberg on Jan. 10 that they intended to reduce purchases of U.S. Treasuries. China is the largest foreign holder of Treasuries, and if the Chinese central bank switched purchases to obligations issued by European governments or Japan, that would send Treasuries into a tailspin. Instead, the yield ended well off its week’s high.
What is the bond market concerned about? Even as the news came out of Japan and China, Canadian officials indicated they believe the risk of President Donald Trump walking away from the North American Free Trade Agreement has increased. After repeated rounds of negotiations, officials from the three countries remain far apart.
The most contentious terms in revising Nafta appear to deal with regulations governing the automotive sector. The U.S. demand that there be not only a specific North American content to qualify for lower tariffs on automobiles, but also 50 percent U.S. content, is facing stiff opposition from its two neighbors. In addition, according to the U.S. proposal, the North American content of automobiles would have to increase from 62.5 percent to 85 percent to qualify for Nafta protection—a demand that Canada and Mexico regard as a job-killer.
There’s more. On Jan. 10, the World Trade Organization posted a report that Canada has filed a complaint alleging that the U.S. had violated trade guidelines in almost 200 instances over decades. The Toronto Globe and Mail called the Canadian stance the trade world’s equivalent of all-out war.
At about the same time, Mexico’s economy minister, Ildefonso Guajardo, said his country would pay for no part of the wall that Trump wants to erect on the U.S. southern border, and would not hesitate to walk away from the trade treaty if the U.S. tried to impose tough terms.
To understand the seriousness of these developments, recall that Canada and Mexico are respectively the two biggest destinations for U.S. exports. Retaliation by either neighbor by imposing countervailing duties, or by instituting restrictions on U.S. firms operating there, could have a major impact on U.S. employment, the rate of economic growth and multinationals’ earnings. Close to one-half of the earnings of companies in the Standard & Poor’s 500 comes from abroad.
With little relief on the trade front in prospect, markets are viewing these developments with growing concern. After several rounds of discussions that made little progress, the next set of meetings will begin in Montreal on Jan. 23. I expect little to come of these talks, and we would be off to the final round of talks in Mexico City next month. With Mexico preoccupied with its presidential elections in July, and U.S. politicians focused on midterm elections in November, expect the trade war to worsen after February.
Bottom line for investors: The eventual outcome for U.S. financial markets may be determined not by the tax plan that came out of Washington. Look for Ottawa and Mexico City to provide a more reliable road map.
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