The U.S. dollar continued to strengthen, rising 2.3% in May versus a basket of major world currencies. Political tensions in Europe pressured the region’s common currency, which fell 3.2% against the U.S. dollar during the month. Additionally, the greenback was buoyed by recent economic data from the U.S. that has been relatively stronger than data from the Eurozone and Japan. Despite May’s strength, we view dollar weakness as a possibility, but the magnitude of any weakness is likely muted versus the experience over the past 18 months. The Fed’s position of being further into an interest rate cycle compared to other major central banks offers the primary rationale for a strengthening dollar. However, U.S. consumer growth tends to widen trade deficits, undermining dollar strength. U.S. tax reform will likely increase domestic fiscal deficits, which tends to lead to a weaker dollar. The rising possibility of other central banks joining the Fed in interest rate “normalization” also restrains any long term enthusiasm for the dollar. Finally, U.S. domestic political anxiety, particularly around U.S./China trade tensions, may pressure the dollar.
Oil prices fell modestly in May, as U.S. production hit record highs and OPEC members considered boosting supply, despite strong global demand for the commodity. West Texas Intermediate crude fell 2.2% percent in May to $67.04 per barrel. We maintain our expected range for WTI of $65-$75 per barrel in 2018. On the supply side, we expect U.S. production to continue to increase, while OPEC production cuts maintain balance. Additionally, domestic labor shortages in many production verticals may contribute to upward price pressure. On the demand side, world oil demand continues to grow, buoyed by improved global growth prospects. Political changes within Saudi Arabia, and possibly Iran, bear monitoring. In our estimation, much of the strength in crude oil over the past 18 months has been driven by the drop in the dollar as the two have historically been negatively correlated. Currency fluctuations remain a “wild card” for oil prices. With the backdrop of synchronized global growth, we are mindful of the possibility of a breakout above our new expected range.
U.S. Trade Policies:
Trade fears dominated headlines through early June as the U.S. Administration continued global trade negotiations on several fronts. The Trump Administration has begun taxing imports of steel and aluminum on national security grounds, complicating relations with The European Union, Canada, and Mexico. Retaliatory measures from these allies were quickly proposed. We believe that President Trump is using these tariffs to create leverage in trade negotiations. In this instance, the President wants to renegotiate the North American Free Trade Agreement (NAFTA) with Canada and Mexico with a goal of shifting investment to the U.S. and reducing trade deficits with these neighbors.
Additionally, President Trump has proposed tariffs on up to $150 billion of Chinese imports, with China retaliating with $50 billion of proposed tariffs on U.S. goods. Again, we believe the U.S. is using the introduction of tariffs as a negotiating tactic to open deeper trade dialogues with China. The immediate aim of the U.S.’ action is to reduce its trade deficit with China. Longer-term, and more importantly, the U.S. goal is to level the competitive playing field in global industries where American companies are forced to share technology, for free, in exchange for access to the large Chinese market. Chinese authorities are not likely to give in easily or quickly on their long time industrial policy.
While the economic consequences of all of these proposed tariffs are minimal, escalating trade tensions between the U.S. and its global trading partners has resulted in financial market volatility. Market participants rightly fear a trade war which would increase the price of goods produced, reduce trade, increase inflation, and reduce output. While the U.S. Administration is serious about its trade agenda, we do not believe a trade war is the desired endgame for the U.S. or its partners in global trade. We expect a long and potentially contentious period of negotiation to continue, with headlines likely adding to global financial market volatility. A series of negotiated settlements with global trade partners continues to be our investment base case.
State and Municipal Finances:
The underfunding of state and municipal pensions has long been recognized. However, we are now putting this simmering issue on our “radar screen.” These types of issues tend to be “kicked down the road” until suddenly they can no longer be ignored. The tipping point may never materialize, but several recent developments have caught our attention: Puerto Rico’s debt crisis, Illinois’ debt rating flirting with “junk” status, temporary government shutdowns in New Jersey and Maine, severe fiscal problems in Connecticut while its capitol city, Hartford, explores bankruptcy, and new tax law which caps the deduction for state and local taxes at $10,000 through 2025. These developments, while no immediate cause for alarm, are particularly striking given they are coming after a multi-year economic expansion, a time when states and municipalities revenues peak cyclically.
European Populist Politics:
Italian politics added to financial market volatility as two populist parties that won elections in March, agreed to form a government in May, with a greater anti-euro undertone than initially perceived. Italian bond yields spiked on the news, recording their biggest one day move since 1992. The move in Italian bonds was driven by the fear that Italy would choose to exit the euro, and introduce a new local currency, which would likely be significantly devalued. A devalued new Italian currency would bring chaos to the domestic banking system, result in capital flight out of Italy, and bring fear of contagion to Italy’s banking and trading partners. After the violent market reaction, cooler political heads prevailed, with less anti-euro rhetoric and Italian bond yields began to fall. While populist politics are gaining traction in Italy, polls show that 60% of Italians prefer to stay in the euro. We view Italy leaving the euro as a low probability event (<10%). But rising populist politics in Europe, which threatens the existence of the common currency, is a risk that is now on our radar screen and will be monitored.