Research

Economic Insights: Trade policy pinball

The markets needed a pinball wizard to navigate trade policy this past week as the U.S. and Mexico go all in, and eventually, all out on tariffs.

June 10, 2019

We viewed potential tariffs on Mexican imports (and any potential retaliatory tariffs from the Mexican government) as unambiguously negative.

Trade Policy Pinball

Trying to follow government policy these days often feels like chasing a pinball. Last Friday, after threatening to impose tariffs on Mexican imports because of immigration issues at the border, the U.S. administration backed off its threat, announcing the two parties struck a deal to suspend tariffs. Thus far, markets have rightly cheered this development. We viewed potential tariffs on Mexican imports (and any potential retaliatory tariffs from the Mexican government) as unambiguously negative. The tight integration of supply chains between the two countries precluded moving production elsewhere in a timely manner, particularly because trade between the U.S. and Mexico often occurs intracompany, not just intercompany. Even if the Mexican peso devaluated in response to the tariffs, which all things equal would have reduced the price of Mexican imports, we still believe that the tariffs would have produced a net negative for the U.S. economy.

That concluded a tumultuous week when sentiment on trade whipsawed. The seeming resolution of the Mexican tariffs at the end of last week takes one more element of downside risk to the economy off the table. But it does not completely remove trade policy (as well as broader geopolitical policy) as a key risk to both the U.S. and global economy this year. The outstanding trade tensions with China remain and there seems little progress to report on those negotiations. The changing geopolitical environment makes maintaining a view on the economy even more challenging than usual. We avoid changing our forecasts until policies become implemented, but the need to analyze and discuss them makes for challenging work.

We believe that the figures overstate the pace of this slowdown and the pullback in underlying economic momentum.

When is bad news good news?

The employment numbers released last Friday severely disappointed. Net job creation fell to just 75,000 jobs in May while the figures for March and April declined by 75,000 thanks to revisions. Those changes bring year-to-date monthly job creation to 164,000 net new jobs. If the economy maintains that pace job creation would fall to its lowest level since 2010, when the labor market started to recover consistently. Even if we assume that later months could get stronger (which sometimes occurs) the year-to-date figure would still rank as the second-lowest during the current expansion, behind only 2016. The ADP figure for private employment in May, also released last week, showed the weakest job creation since March 2010. Taken together, the two data points show slowing in job creation. The public markets took these developments as a somewhat positive sign, reaffirming the belief that the Fed would cut interest rates this year because of the weakening in the economy.

Yet we believe that the figures overstate the pace of this slowdown and the pullback in underlying economic momentum. Other key labor market indicators, such as the unemployment rate (still at a half-century low of 3.6 percent) and weekly initial unemployment claims (still hovering near half-century lows) do not indicate the level of deterioration in the labor market implied by May’s job data. And we view the slowdown in job creation as more of a supply-side issue than a demand-side issue. Employers, particularly small-size and medium-size employers, are still struggling to fill vacant positions which remain at elevated levels. We believe that underlying momentum is slowing as fiscal stimulus fades, but we think the labor market data overstates this case.

What does the Fed do now?

These developments put the Fed squarely in the spotlight. Last week both Chairman Jerome Powell and Vice Chairman Richard Clarida both suggested the Fed would take “appropriate” measures if weakening in the economy occurred. We concede that political events challenge them, just like they challenge us, but we are not alone in wondering about the Fed’s credibility at this juncture. After walking back their forecast for future rate increases in a short period of time, it now appears that the Fed’s default stance is for loosening, not tightening. This harkens back to previous iterations of the Fed making “mid-cycle” rate cuts in response to economic challenges. Yet, we still see enough strength in the economy and not enough tightening in financial conditions to wonder if such a move (or moves) should occur. Moreover, it also raises the question of whether the Fed should undertake this course. The Fed’s official “dual mandate” charges it with: (1) price stability (currently defined as 2-percent target rate of inflation), (2) full employment, a somewhat subjective calculation, but even loose measures indicate that the economy sits at or near such a level, (and 3) stable long-term interest rates. Nothing in that mandate charges the Fed with extending the business cycle or “putting more time on the clock” though the Fed does this at times. One could argue their mandate implies but does not state this objective. We have two main concerns if the Fed embarks on this course. First, we worry about the Fed undermining its trust if it continues to act capriciously in setting its outlook. Second, and this is a concern we previously raised, we worry that continuing the policy of relatively loose monetary policy at a time when the economy remains on relatively firm footing raises the risk of an asset bubble. We still think the economy does not need a rate cut in 2019, but increasingly we find ourselves in the minority on this view.

What we are watching this week

Inflation readings could provide fodder for those in the camp that thinks the Fed should loosen policy this year. The producer price index (PPI) and consumer price index (CPI) for May should show modest gains in headline and core inflation, keeping the year-over-year changes in inflation relatively unchanged. On the other hand, we expect a rebound for retail sales activity in May, with the consumer continuing to prop up the economy as other economic drivers (such as investment) weaken.

What it means for CRE

For commercial real estate (CRE) we still see solid fundamentals propelled by good economic momentum. Even in the labor market data, we see hopeful signs. Employment in the business and professional services industry, a key demand driver for office space, continued its pace of solid job creation. Leisure and hospitality employment also continued to grow at a brisk pace, a positive sign for the hotel sector. Job gains among those in the 20-34 age group accelerated in May while wage gains among non-supervisory employees (also often younger workers) maintained a rate of growth the exceeds overall wage growth. Both developments portend continued demand for apartments. On the negative side of the ledger, retail job losses continued in May, reflecting the structural changes occurring in the retail sector. On the capital markets side, we reiterate our concern that low interest rates risks producing an asset bubble, including CRE, particularly if fundamentals and the economy remain relatively robust. More on this topic is coming soon from us.

Thought of the week

According to a recent study, the number of states with a middle class (defined as those households earning between two-thirds and twice the state's size-adjusted [3-person equivalent] median household income) greater than half of all households has fallen from 43 in 2000 to 33 in 2017.

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