Current macro situation - Working through tariff supply shocks

Cutting through the rhetoric about tariff wars and the global growth, it is important to walk through a simple macro narrative that takes us to the current environment. 

Tariffs are supply shocks to the economy. They shock the cost structure for importers. Importers have to pay the price of the tariff and determine whether to pass-through the cost or reduce their margins. Exporters will see their product demand change given the cost of their goods have increased to their buyers. They have to lower their prices to help offset tariff costs. The supply chain is disrupted and import firms have to determine whether they change where they get their goods. This process will take some time, so the tariffs of last year are just now impacting growth. 

The Fed has responded to the supply shock by reversing its tightening policy. The impact of this reversal will also take some time to work through the real economy. The hope is that Fed rate reductions will offset the tariff shocks in the US and the rest of the world. However, the timing between shocks and monetary policy response may be off.

Unfortunately, there is also a higher uncertainty shock. Given uncertainty in policies and politics, the policy uncertainty index from the University of Chicago has exploded to the upside. This uncertainty will cause a delay with investment decisions. Who is going to commit to a longer-term project if the environment is unknown? Again, the hope is that a lower cost of capital from the Fed dropping rates will offset this uncertainty. 

  

During this environment we have seen the ISM diffusion index fall below 50 and global PMIs falling or at levels below 50. The tariff wars have had an impact on manufacturing, although the service indices are still holding up better on a relative basis. Generally, a rising ISM above 50 will represent a risk-on environment. A declining ISM will represent risk-off and a declining ISM below 50 risk can be viewed as a risk aversion environment. The bond rally corresponds with a switch to risk-off and risk aversion. 

The impact of these shocks will be seem in forward earnings. Earnings will  also become more disperse as firms in manufacturing will be hit harder than the service sector. These earning declines will lead to a reversal in equity prices. The financial markets push-pull will be between a further impact from the tariff shocks and uncertainty and the impact of Fed rate cuts. We are seeing downward revision of current global growth, but expectations of increases in 2020. The key question is whether global monetary policy has enough power to offset these shocks.