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Posted on JUN 5, 2019

Investment Commentary | Wednesday, June 5

This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.

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Can You Push Too Far?

Last weekend my son and I took our annual sojourn to Road America for the MotoAmerica Superbike race series. It was a great weekend of racing with some exciting finishes. The last Superbike race of the weekend found two rivals battling it out around the 4.05 mile road course. On the last lap in the last turn, one of them pushed too hard to overtake and crashed. He lost the race and his rival closed the gap on the series championship.

Too Many Tariffs

The policy events of the past several days have me thinking we've seen a push too far with the announcement of tariffs on Mexico to get them to the table on our mutual border issues. We have been sanguine on the effect of tariffs given the high level of business and consumer confidence. However, the uncertainty surrounding foreign policy and the recent rapid fire policy prescriptions have the potential to more significantly lower our economic growth expectations for the rest of 2019. We believed that growth could be between 2.5% and 3.0%. However, with the recent rhetoric from China and the Mexican finance minister, we think that may be in jeopardy.

On Thursday, President Trump announced plans for escalating tariffs on Mexico, our third largest trading partner, effective June 10. The tariffs would start at 5% and ratchet up to 25% by October if we don't see improvement in Mexico's efforts to reduce cross‐border migration. With $347 billion in goods and services crossing the U.S. and Mexican border last year, an increase in tariffs will cost consumers on things from avocados to Ford F‐150s. Tariffs increase the cost of goods sold, and those higher prices are either picked up by the company selling them or the consumer buying them. Either way, they reduce growth.

We've noted in previous writings that tariffs have the potential to reduce growth by as much as seven‐tenths of a percentage point. That doesn't sound like much, but when applied to a nominal growth estimate of 4.5% to 5.0%, subtracting seven-tenths of a point equates to growth around 10% lower than hoped for. The Mexican tariffs could reduce growth by another four‐tenths of a percentage point if fully implemented. These factors in combination would make it difficult for our original estimate of 2.5% to 3.0% to be believable.

Bond Market Message

The bond market sent a dire message last Friday as the yields on Treasury bonds declined precipitously and the extra yield earned on corporate bonds turned higher (implying an increase in risk). As an example, the 2‐year Treasury is now trading at 1.86% after trading near 2.2% a week ago Friday. At its peak last October, the yield was above 3%.

It seems bond investors are pricing in a more significant decline in economic growth and pushing the Federal Reserve even harder to reduce the level of interest rates this year. We believe the Fed will remain data dependent and need to see more hard evidence of a slowdown. Having said this, the Fed chairman was in the news Monday acknowledging that a prolonged trade battle has the potential to weaken the economy and cause the Fed to act sooner. Stocks rallied more than 2% Tuesday on this news.

Coming into 2019, investors were worried that the Fed would hike rates at least twice. We believe the Fed will likely stand pat until it sees further evidence of worsening economic data, which is likely if business and consumer sentiment shift more negative due to trade issues.

Measures of confidence, however, remain near their all‐time high. The University of Michigan Consumer Sentiment Survey currently stands at 97 after a post‐recession peak of 101. With unemployment below 4% and wage growth pushing higher than 3%, consumers have reason to be upbeat. However, if all the tariffs suggested by the administration are implemented (a scenario we don't believe is likely), inflation would rise enough to cause a pinch on consumer spending.

This week, the Purchasing Manager's Index, or PMI, was released and showed a decline beyond what was expected. Stocks sold off on this news, although for our part we don't believe the recent decline represents a protracted weakening of the economy. However, with trade rhetoric escalating and the Mexican tariff showing the administration is willing to use this tool unconventionally, we will continue to manage portfolio risk to the lower end of our range.

Unlike the racer on Sunday who used too much front brake to make the turn and ended up crashing out, we hope that the Trump administration is only using the current rhetoric and tariff suggestions to negotiate a better position. President Trump and Premier of China are expected to meet at the late June G20 meeting. The USMCA (U.S., Canada, Mexican trade deal) needs to be approved by Congress. These events may be leading to the show of commitment to tariffs as a negotiating tool. We hope it doesn't go too far.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.
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