Bond markets seem to be shouldering the burden without complaint, but the next six months – and beyond – could prove interesting.Richard Drew/The Associated Press
It has been a wild six months, but don’t tell that to the stock market. As far as it’s concerned, the first half of the year has turned out just great.
Just to recap: During that patch, Washington has launched a global trade war, the real war in Ukraine has blazed with undiminished ferocity, and Israel has ignited a new war against Iran. Closer to home, the ambient fug of corruption in Washington has grown denser by the day, while Canada’s economy has strained to perform under the weight of Donald Trump’s tariffs.
Stock markets, though, see no evil. In Canada, the U.S. and Europe, benchmark stock indexes are up between 4 and 8 per cent since January. The S&P/TSX Composite Index, the S&P 500 index and the Nasdaq index are all at or near record highs.
As far as markets are concerned, the glass is most definitely half-full.
Could they be right? Sure, it’s possible. Despite all the nasty stuff that happened in the first half of the year, corporate earnings held up just fine. Perhaps this happy state of affairs will continue.
But not everyone is convinced. One troubling sign is the continued popularity of gold, the ultimate haven asset. If things are so great, why are so many people buying bullion?
The U.S. dollar is another flashing red light. It has sunk 10 per cent against a basket of other currencies since the start of the year. If the world’s largest economy is booming, why are so many people bailing on the greenback?
You can put forward reasonable explanations for these anomalies. Still, it’s worth examining some of the assumptions behind recent market gains. Investors may want to think about three questions in particular.
The first is whether the tariff truce will hold. It’s difficult to follow what is happening with Mr. Trump’s ever-changing trade policy, but several important dates are coming up.
The first involves what the U.S. President humorously calls “reciprocal” tariffs. (They’re actually not reciprocal at all, but never mind.) On April 9, as you will recall, Mr. Trump imposed these sweeping levies on a multitude of jurisdictions (including uninhabited islands near Antarctica). Then he granted a 90-day pause on the part of the tariffs over 10 per cent. That deadline expires July 8.
Mr. Trump followed up on that confusing barrage of announcements by threatening the European Union with 50-per-cent tariffs in May. Then he agreed to delay those levies, too, this time until July 9.
In the case of Canada and Mexico, he imposed crushing tariffs, then agreed to carve-outs in some areas. Canada is trying to strike a comprehensive new deal, although the President on Friday seemingly terminated those talks via a social media message. That makes a self-imposed deadline of July 21 seem even more unlikely.
The common belief on Wall Street is that Washington is likely to postpone further action and eventually settle for a baseline 10-per-cent tariff on most countries and most goods, which would be painful but not crippling. However, a deal is never a final deal when it’s with Mr. Trump, and trade turmoil could erupt again.
Even if it doesn’t, the full impact of the tariffs remains to be seen. The Yale Budget Lab estimates the levies will cost the average U.S. household about US$2,000 a year. For now, Wall Street seems happy with that painful loss of buying power – which is rather strange when you think about it.
Perhaps investors are counting on a productivity boom from artificial intelligence to offset the tariffs. Which brings us to the second key question: Will AI actually goose the economy the way many people hope?
It’s certainly helping to drive the stock prices of companies associated with AI. What’s concerning, though, is the lack of significant real-world payoffs to date. Yes, chatbots are amazing machines and can do impressive things in test situations. However, they have yet to boost productivity numbers in the U.S. or elsewhere.
This could just be a matter of time. For now, though, investors are assuming a lot. Largely as a result of enthusiasm around U.S. technology, they have boosted the S&P 500 index, the benchmark for U.S. stocks, to valuations far above those of its Canadian or European counterparts. This all makes perfect sense if you assume that profits will grow faster in the U.S. than elsewhere. But if AI comes up short, or if Chinese-made AI turns out to be just as good as the American variety, Wall Street’s pricey shares look vulnerable.
To be sure, there is one simple reason to stay positive about the U.S. stock market: Say what you will about the wisdom of its fiscal policy, but the U.S. government is spending vast amounts of cash it doesn’t have to stimulate its economy. That is boosting corporate profits.
However, this go-for-broke strategy raises the third question: How long will bond investors continue to fund the massive U.S. budget gap without demanding much higher interest rates?
The U.S. deficit this year is expected to come in at more than 6 per cent of its gross domestic product. That is a level of government borrowing appropriate to wartime or a deep recession. Yet Washington is doing it at a time when the U.S. is at peace (more or less) and the economy is expanding.
For now, bond markets seem to be shouldering the burden without complaint, but gold’s lofty price and the downward course of the U.S. dollar suggest that confidence in Washington’s fiscal management is slipping. The next six months – and beyond – could prove interesting.