No Preemptive Moves
By looking at the Federal Reserve’s meeting statement, you’d think not much had happened since the prior meeting. The statement noted that economic activity expanded at a solid pace, the unemployment rate had stabilized at a low level, and inflation remained somewhat elevated. With no official update to the central bank’s official economic projections, arguably the most important update in the statement was the declaration that uncertainty on the outlook had increased further, and the risks of higher unemployment and higher inflation (aka stagflation) have risen. For now, it appears investors think labor market and growth concerns will take precedence over inflation. Over the next two years, investors expect headline CPI to average 2.84% and the central bank to lower interest rates by 1.10 percentage points (or four interest rate cuts with a 40% chance of a fifth). Compare that to the beginning of the year when 2-year inflation expectations were 2.53% and 2-year rate cut expectations were 0.62 percentage points.More Rate Cuts Despite Higher Inflation Expectations
Under normal circumstances, such a trend might prompt the Fed to consider easing monetary policy to support growth, like it did in 2018-19. However, inflation was below the Fed’s target then – the same cannot be said now. Chair Jerome Powell explicitly mentioned that they wouldn’t be able to preemptively act to support the economy this time, since cutting rates could exacerbate tariff-induced inflation and unanchor inflation expectations.
The wait-and-see approach signals a higher bar for policy easing, despite what some investors might be hoping for. Until the central bank gets the greater clarity it’s seeking, it seems the likeliest future moves it will make are no moves at all.
Global Trade Bellwether
In this unfamiliar new world we find ourselves in, the Fed takes a backseat. In its place, economic data and the resilience of global trade take center stage. South Korea, with its export-driven economy and significant role in global supply chains, is a key indicator. The country’s status as a global economic bellwether stems from its position as a major exporter. It’s deeply integrated into global value chains, particularly in critical areas such as semiconductors, consumer electronics, and automobiles.South Korea Exports: Leading EPS Indicator
South Korean exports unexpectedly grew by 3.7% year-over-year in April, driven by a surprise surge in imports later in the month. This marked the third consecutive month of expansion, though below what was seen last year.
A significant driver of this growth was a surge in semiconductor exports, an acceleration from an already strong March. Notably this occurred alongside a decline in exports to the United States, while exports to other Asian neighbors and the European Union saw increases. The shift away from the U.S. could be a potential early sign of global trade rebalancing toward the Eastern hemisphere.
Implications for corporate earnings are mixed. While first quarter results have been generally solid, EPS guidance momentum is at its most negative in a decade, according to Bloomberg, with trade policy uncertainty throwing a wrench in what was supposed to be a banner year for businesses.
These dynamics underscore just how interconnected the global economy is. U.S. tariff policy has a direct and measurable impact on key trading partners like South Korea. The economic health of these export-oriented nations, in turn, influences global demand, which then affects the earnings of U.S. multinational corporations. The Fed statement speaks to this as well, noting that its assessments will take into account international developments.
Fleeting Volatility
The impact of trade policy uncertainty can be felt across asset classes, with broad volatility spiking in early April to its highest levels since the onset of Covid. However, volatility has retreated relatively quickly since then, despite the ongoing uncertainty.Multi-Asset Volatility
Even though the multi-asset volatility measure in the above chart has declined from its recent peak of 185 to 124 as of May 7, it remains above typical historical levels. A decline from “very high” to “high” is still high.
The market is somewhat aligned with the Fed’s cautious tone, though it looks like there’s more optimism priced in. This reflects, at least partially, a degree of hope for the future overriding the available facts on trade policy, particularly regarding tariffs on China.
Just how this will all play out remains up in the air, but every day that passes without a resolution on trade inflicts damage on the U.S. economy. In the meantime, investor sentiment will probably be reactive to news flow concerning these negotiations, with both successes and failures liable to reignite market volatility. The relatively recent calm might be more fragile than it appears, and the Fed might not step in to save the day.
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