Friendly Fire

Chaos theory: The theory states that small changes can cause many unexpected outcomes in places never anticipated. It seems the administration is borrowing from Mark Zuckerberg’s strategy of “move fast and break things.” It may be a good approach when starting out building a company or business, but it’s a tenuous tactic if you are the U.S. government. Breaking the US government or its funding mechanisms could cause disruptions from which it is difficult to recover. While there is a need to reduce federal spending, a rapid change can damage economic output and lead to significant difficulties for the interconnected workings of our entire economy. This lab experiment creates unpredictable outcomes, hence the amount of volatility we see in the stock market. This morning’s news about Mexican tariffs being paused for a month is encouraging; even so, the investment approach should be cautionary as we traverse uncharted territory from this untried approach.

‍

China Vanke Update: A Case of Unintended Consequences

‍

Tariffs have now shrunk global macro down to three countries, and we need to wait for the full retaliation story to be revealed, as well as Washington’s reaction, if any. We are wondering whether the initial fear this weekend could reverse to optimism. 

We wrote last week that the fear of property developer China Vanke facing potential default as tariffs loom “could motivate the Chinese to finally mobilize fiscal policy and inject funds into these troubled real estate developers.”  Beijing made a significant change last week, and now that tariffs are a reality, Washington’s action to put major economic pressure on the Chinese could cement Beijing’s resolve, and the net outcome could be a stronger economic outlook for their economy.

China Vanke’s bondholders interpreted the complicated action last week as tantamount to a nationalization bailout. The Shenzhen government’s Assets Supervision and Administration Commission ended up investing in Shenzhen Metro, their subway operator. Shenzhen Metro already owns 27% of Vanke and will place those funds in Vanke. Additionally, its Chairman is replacing the current Chairman, solidifying the state supervision. The expectation is that despite the economic pressure from tariffs, housing sentiment, pricing, and sales can improve now that public funds are being provided for direct liquidity injections into private firms.

A watershed moment? Time will tell. However, investors were waiting for direct Chinese fiscal policy support, which augurs well for Chinese markets in the long run. Even though Washington may be disappointed by implementing tariffs that could indirectly revive Chinese investor enthusiasm, it will eventually boost sentiment globally and help support a U.S. equity rally.

‍

BoC: The Northern Lights Dim

‍

The Bank of Canada (BoC) was scared, and rightfully so. Fear of tariffs made the bank lighten things up at their monetary policy meeting on Wednesday in case things got darker. The central bank not only cut rates 25 basis points but also stopped Quantitative Tightening, putting an end to shrinking its balance sheet to halt liquidity withdrawals. Governor Tiff Macklem said the tariff threat pushed them to move preemptively to get ahead of the potential inflation stemming from higher import prices and supply chain disruptions; the latter caused inflation globally during the pandemic. Because the U.S. placing tariffs on them will also lower Canadian manufacturing and sales, Macklem described tariffs as a “complex monetary shock” due to their stagflationary impact. Currently, the Bank is more concerned about supporting growth because their scenario of permanent 25% tariffs results in a 2.5%-3.5% reduction in growth. Since they are forecasting 1.8% GDP growth for 2025 and 2026, a trade war—Canada retaliated this weekend—lands them in a recession.

To complicate matters further, if inflation starts to rise too quickly, then monetary policy must flip and become restrictive to keep imported inflation from spreading into other prices and wages. If they need to tighten because of concern that consumer and business inflationary expectations become permanent, that will deepen the recession.

This BoC meeting was extraordinary in its candor because the head of a major central bank discussed the stagflationary impact of tariffs, unlike Chairman Powell, who avoids any discussion about potential problems. Powell blames his silence on the difficulty of quantifying the economic impact, but it is merely a tactic to avoid talking about the need to raise U.S. rates. He may be doing so to keep investor spirits up, to avoid any conflict with the new administration or both.

The BoC’s Monetary Policy Report, which included the recession forecast, pointed out damage to the U.S. economy if Washington embarks on universal tariffs. Any intermediate good that is imported by U.S. manufacturers will carry a higher price because of the tariffs, and the finished good will be less competitive on world markets because other countries can produce the same item cheaper because their input costs won’t be inflated due to their own tariffs. The result would be that U.S. exports will decline. This would depress manufacturing revenues for U.S. firms and weigh on stock market valuations, creating a more pessimistic stock market outlook relative to foreign equities.

‍

Error of Omission

‍

Deleting ten small words is all it took. The Federal Open Market Committee (FOMC) statement released after their January meeting removed the phrase “Inflation has made progress toward the Committee’s 2 percent objective” and just wrote “Inflation remains somewhat elevated.” This is a significant change in our eyes.

You may agree with Jerome Powell, who dismissed any significance of the change during his press conference. However, the last time the statement contained just “Inflation remains elevated” was between March and November of 2023, when the Fed was still tightening (the last rate hike was July 2023). While Powell may disagree, the omission that leaves just “inflation is somewhat elevated” reflects what the majority of the FOMC participants are thinking, and that is that with tariffs on the horizon, any thought of inflation moving toward the 2% target is toast.

The next meeting on March 18-19 will also contain an updated Summary of Economic Projections (SEP). What we also know from the December Fed minutes is that 2/3 of the December SEP inflation forecasts did not consider a tariff scenario. Even with only 1/3 of the forecasts incorporating the inflationary aspects of tariffs, the average upside risks discussed were already pushed up significantly. They can only go higher in the March SEP. The last time the Fed considered tariffs was in 2018, and there was discussion of resisting rate hikes because the inflation can be temporary. The Fed is better off omitting the “transient inflation” language, or else the markets will revolt. 

‍

What to Look for This Week

‍

1. Friday, February 7 at 8:30 a.m. E.S.T. December Nonfarm Payrolls. We also receive the latest benchmark revision to the employment data, but we are focused on Average Hourly Earnings, which has not been above 4.0% since H1 2024. An uptick above there starts discussion about wage inflation. Tuesday February 6 at 10:00 a.m. E.S.T. JOLTS Job Openings Survey for November (always lagged one month). Look at hiring rate for further weakness, which would be significant because that was after election and Octobers’ 3.3% rate was the lowest since March 2020’s 3.1%.

2. Potentially a bigger market mover than the employment report, Wednesday February 5 at 12:00 p.m. E.S.T, the U.S. Treasury Department releases its Quarterly Refunding Announcement. Treasury Secretary Bessent has been a proponent of auctioning fewer Treasury Bills and issuing more longer-term securities. If that occurs, as it did in 2023, long rates will increase and stocks will fall significantly. Given the tariff news and the debt-limit issue, we do not expect any surprises now, but they are coming.

3. Wednesday, February 5 at 10:00 a.m. E.S.T. January ISM Non-Manufacturing Index. We are looking at the Prices subcomponent, which hit 64.4 in December, the highest since March 2023. Services prices are what is keeping inflation elevated, so any new highs will likely increase fixed income yields.

FOMC Voters Speaking: The major one is Governor Thomas Waller at 2:30 p.m. E.S.T. on Thursday: in his last speech, he acknowledged that inflation was sticky but listed his reasons why he thought prices would continue to fall toward the Fed’s 2% inflation target. We expect him to double down. Governor Michele Bowman is at the opposite end of the spectrum and speaks Wednesday at 3.00 p.m. E.S.T. and Friday at 9:25 a.m. E.S.T., both on Bank Regulation, but may comment on inflation. Governor Adriana Kugler speaks at noon E.S.T. Friday on productivity.  Wednesday February 5 at 1:00 p.m. E.S.T Chicago Fed President Austin Goolsbee will deliver a speech on the current economy which could be a market mover.