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Written by: Kevin McCreadie | AGF Investments
Can global equity markets climb higher in a geopolitical climate that only seems to be getting more precarious?
We believe financial markets have performed relatively well so far this year primarily because corporate earnings growth – and the growth of the economy more broadly – show few signs of slowing down despite the highly-volatile macro backdrop that investors find themselves navigating these days. This is particularly true of the S&P 500 Index in the United States, yet to varying degrees also explains why the MSCI Europe Index and S&P/TSX Composite Index in Canada are still trading near all-time highs as well.
Whether investors can keep climbing this proverbial “wall of worry” may come down to the new U.S. administration’s policy agenda as it ultimately plays out over the next four years. While market participants were initially enthused about the business-friendly, pro-growth aspects of this agenda (i.e. tax cuts and deregulation), their confidence in U.S. President Trump’s overarching economic strategy has been clearly shaken and there is now significant debate as to how certain policies could affect economic conditions and corporate profits—especially when considering them together and not just in isolation.
Tariffs
Take tariffs, for example. Equity investors have been on high alert about them to date, but not quite panicked, presumably because most of what’s been threatened has yet to be implemented, leaving many to question if they ever will be. How long this cat and mouse game lasts remains to be seen but should the U.S. administration make good on its threats, few doubt the impact that U.S. levies on imported goods could have on the economies involved.
For one, U.S. tariffs may result in higher prices for imported goods, leading to a higher U.S. inflation overall and diminished prospects for more rate cuts in the future. At the same time, countries being taxed could see weaker demand for the goods they are exporting to the U.S., setting up the possibility of slower economic growth and declining corporate profits. Worse still, countries being taxed could respond with retaliatory tariffs of their own, which we expect could transpose these effects and magnify any potential fallout from them.
That said, not everyone agrees that all tariffs are a potential lose-lose. In fact, reciprocal tariffs (a proposal to impose U.S. tariffs equal to those that other countries impose on U.S. goods) could be a win-win. “Reciprocal tariffs are not necessarily a negative outcome, as the impacted countries could choose to lower their tariffs,” CitiGroup researchers said in a recent note. “In that case, global trade could actually rise rather than fall.”
Energy Production
Even if widespread tariffs are imposed, it’s important to consider their effect on global economic conditions may be influenced by other policies. To that end, the U.S. administration plan to increase oil and gas production could result in lower energy prices, which could offset the higher cost of living that might be associated with tariffs (even if energy is not included in the official calculation of a country’s core inflation rate).
Similarly, if the U.S. administration ends up brokering a deal to end the Ukraine War, it could result in Russian oil sanctions being removed, thus creating more global supply and even lower oil prices, potentially.
Granted, how much lower is still arguable. Russia’s crude oil output only saw a modest decline following sanctions from the West, largely because it was mostly re-routed to different buyers, which continue to buy Russian oil to this day.
Fiscal Spending
Making matters more uncertain is the rollout to date of the U.S. administration’s fiscal policy and its decision to dramatically cut government spending in the name of efficiency, while also hinting at tax cuts that could go beyond the extension of existing ones that have been in place since President Trump’s first term.
Indeed, many believe shutting down federal agencies and/or dramatically reducing the government’s workforce could be an added offset to higher U.S. tariffs because it could lead to lower inflation and falling interest rates as the U.S. deficit starts to shrink.
Yet, to the extent that proves true, we believe the effect may not be as great as some predict. After all, a few hundred billion in cuts stills leaves a deficit that is well over US$1 trillion, nor will it put a dent in the gargantuan U.S. debt that is now US$36-trillon and counting.
And won’t corresponding tax cuts somewhat diminish the impact of spending cuts, rendering them less deflationary than would otherwise be the case? And what if these cuts lead to a significant rise in unemployment, an outcome that governments are generally meant to mitigate, not actively create? Sure, that could tip the scales more towards deflation and lower rates, but at what cost to U.S. economic growth and the global economy by extension?
Clearly, there are more questions than answers when it comes to the U.S. administration’s fast evolving agenda. For every potential positive it may have on the economy and financial markets globally, it seems investors are being forced increasingly to consider the potential negatives that could arise from it as well.
In fact, this dynamic may explain why the S&P 500 Index and S&P/TSX Composite Index netted big gains early in the year but have waned in performance since the inauguration. Moreover, we expect that trend may only get more magnified as we near the end of the first quarter. This has often been a seasonally difficult time for financial markets historically, but this year it lines up with a looming U.S. government shutdown and more tough tariff talk between the U.S. administration and its next-door neighbours, Canada and Mexico.
Still, that’s investing for you these days. Despite all the certainty of last quarter’s strong earnings growth and the ongoing resilience of the economy, there is a persistent uncertainty about the current environment that could make further gains more difficult to come by.