Government Policies Take Center Stage

The U.S. equity market had another volatile week. The week started with sloppy performance despite strong earnings results. On Friday, the broad market was lifted by strong technology and financial shares, erasing almost all losses for the week. Main events last week included the Fed meeting and a high level delegation of U.S. trade negotiators meeting with Chinese authorities in Beijing.

On Wednesday, the FOMC meeting voted unanimously to keep the Fed target interest rate at the current range of 1.5% to 1.75%. Inflation picked up in March, with core PCE at 1.9%, approaching the Fed target of 2%. Fed members emphasized their inflation target is “symmetrical”, signaling their willingness to let inflation go higher than the target. The FOMC statement noted expectation that inflation will “run near the Committee’s symmetric two percent object over the medium term. Risks to the economic outlook appear roughly balanced.” There was no mentioning of concerns over recent market volatility. Overall, the meeting statement reinforced market expectation of another rate hike in June. Whether we will get three or four rate increases this year will depend on market developments.

The Fed’s objective is to reach maximum employment, stable prices, and moderate long-term interest rates. The FOMC traditionally uses monetary policy to reach this goal, by cutting interest rate to stimulate economy and increasing interest rates to prevent economy from overheating. In March 2018, the FOMC forecasted that the “natural” long-term unemployment should range from 4.3% to 4.8%. As the unemployment rate has been holding steadily below the Fed’s median estimate of 4.5%, inflation expectations will be a key driver for the pace of tightening. Inflation has picked up quickly this year, making some investors worried that the Fed will adopt a more aggressive policy.

On Thursday, U.S. representatives, including Treasury Secretary Steven Mnuchin and Commerce Secretary Wilbur Ross, arrived in China for a two-day trade negotiation. One key demand from the U.S. is for China to lower its tariffs in order to cut the trade deficit by at least $200 billion by the end of 2020. Given that the U.S. tax policy is stimulating domestic demand, it would be difficult to reach such a trade target.

Other issues raised included removing Chinese subsidies to local high-tech companies and increasing intellectual property protection. Subsidies are key components to support the Made-In-China 2025 initiative, where China seeks to shift from a low-cost manufacturing to a high-technology-based economy. We see a low likelihood that China would accommodate the demand on subsidies. At the end of the two days of negotiation, the two parties reached agreement on some issues but have not made a final trade deal. In the upcoming weeks, we could see a rise in trade tension as the world’s two largest economies revisit the negotiations.

On Friday, the U.S. job data was released. Even though the number of new jobs created was less than expected, the unemployment rate dropped below 4 percent for the first time in 18 years. Surprisingly, wage growth declined in nine of the 1 4 sectors, slightly reducing concern of upward pressure on inflation. The slow wage growth raised the question whether the real full employment level is below the Fed forecast of 4.5%. Furthermore, the relatively low market participation rate could have biased unemployment levels downward. These softer job data points give little support to a more aggressive rate hike this year.

Looking to the week ahead, the U.S. April consumer prices index (CPI) will be released on Thursday, providing more hints on a potential June rate hike. Also, NAFTA talks will resume in Washington, with the unofficial goal of having an agreement by mid- May. Other key market drivers include the Bank of England’s monetary policy update and President Trump’s decision on the Iranian nuclear deal.

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