Summer months are typically a quiet time for the markets. Recent events, however, may disrupt this tradition. Threats of escalating trade wars have cast a pall over equities, and numerous geopolitical uncertainties continue to push investors toward a more cautious stance. A desynchronization in global growth as well as a divergence in central banks’ monetary policies have contributed to U.S. dollar strength and wreaked havoc on emerging markets. Currencies of emerging market countries with significant external funding requirements came under particular pressure. Oil prices have risen sharply, and the CBOE’s VIX Index climbed steadily higher through June, signaling increased investor angst. While economic growth in the U.S. has been robust, signs of deceleration have emerged overseas, especially in Europe, Japan, and China.

The summer months are traditionally a good time to take vacation, but it seems the summer of 2018 could take a different course.

The U.S. economy continues to thrive:

• The unemployment rate rose to 4.0% in June after dropping to 3.8% in May, the lowest level since 2000.
• Wages have been inching up, showing a year-over-year increase of 2.7% in June.
• Consumer spending has been robust; retail sales rose 0.5% in June (6.6% year over year).
• Housing starts, which have been hindered by high lumber costs and a shortage of labor, surged to near an 11-year high in May, although they dropped in June to the lowest point since September 2017.
• Business optimism and consumer confidence indices remain elevated. The National Federation of Independent Business reported that its index of small business optimism posted the sixth-highest level in June.
• While real U.S. GDP growth in the first quarter was a mere 2.0% (annualized), second quarter growth hit 4.1%, the strongest quarterly gain since 2014. But growth is expected to ease off from that level, which was driven in part by a big surge in exports ahead of the expected imposition of tariffs.
• Inflation is moving up but remains contained. The Producer Price Index jumped 0.3% (3.4% y/y) in June, due in part to the rising costs of transportation. The y/y increase was the biggest since the end of 2011. Consumer prices rose 0.1% (2.9% y/y), the biggest annual jump since 2012.
• WTI Crude prices climbed 14% y/y and appear poised to rise further given a sharp drop in supply and President Trump’s threats of sanctions on countries that continue to import from Iran.
• The Fed’s favored inflation measure, the Core Personal Consumption Expenditures Index, rose 1.9% in June, in line with the Fed’s target of 2% for that index.

Against this backdrop, the Fed raised short-term rates for the second time in 2018, bringing the Fed Funds rate to 1.75% – 2.0%. The Fed expects two more rate hikes this year and three more in 2019. The U.S. dollar appreciated more than 5% over the course of the quarter (versus a basket of currencies) given higher interest rates, the strength of the U.S. economy, and relative weakness in Europe and Japan.

In the face of all of the good economic news (and perhaps because of it), the White House imposed a 25% tariff on $50 billion of imports from China.

While these tariffs are not expected to have a meaningful impact on U.S. GDP (roughly -0.2%), the administration has threatened to apply additional tariffs on at least $200 billion of goods should China retaliate. That move would have a much more significant impact on U.S. GDP as well as add to inflation.

Further, the White House announced new tariffs on steel and aluminum from Europe, Mexico, and Canada. In response to President Trump’s move, European Union members unanimously backed a plan to impose import duties on €2.8 billion worth of American products. The U.S. and the EU have agreed to take steps to find a way to resolve the dispute, but the markets have clearly expressed displeasure in recent days around the potential impact of trade wars on the economy.

Slowing in Europe

Conversely and in contrast to 2017, data in Europe suggested slower growth. German factory orders unexpectedly dropped for a fourth month in April. A European Commission Index of consumer sentiment fell to an eight-month low in June. Turmoil in Italy also worried investors. Initial attempts by the Northern League and 5 Star Movement to form an anti-establishment government coalition were rebuffed by the Italian president’s veto of the parties’ choice of a euro-skeptic finance minister. While a compromise was reached, investors are wary of the new government’s fiscal discipline. Italy’s national debt is among the highest in the world and growth remains meager; unemployment hovers around 11%, and the new government includes leaders who have talked of leaving the euro. Italian bond yields surged 100 basis points on the news. Finally, Brexit negotiations between Britain and the EU have stalled, raising the threat of a “hard” Brexit come March 2019.

In recognition of these headwinds, euro zone central bankers trimmed their outlook for growth in 2018 to 2.1%, down from the previous forecast of 2.4%. The European Central Bank announced plans to cut in half (€30 billion to €15 billion) its monthly asset purchase program beginning in October 2018, and fully stop purchases by the end of 2019. However, this timing was further out than markets had expected, and reinvestment of principal payments from maturing bonds is expected to remain for “an extended period of time after the end of the net asset purchases,” according to the ECB. The Bank also kept rates unchanged during the quarter.

China also showed signs of slowing. Both industrial output and retail sales rose less than expected in May and fixed-asset investment growth has also slowed. Japan’s economy contracted for the first time in two years. The world’s third-largest economy shrank by 0.2% in the first quarter. Stimulus measures are expected to remain in place in Japan as inflation remains significantly below target.

As of the end of the quarter, valuations remained full across most asset classes (emerging markets being the notable exception) and numerous storm clouds loomed on the horizon. Could rising interest rates, higher energy prices, U.S. dollar strength, Brexit woes, looming trade wars and/or other geopolitical concerns derail the 108-month-old economic expansion, the second-longest on record, or will sunny skies prevail? While we cannot predict the future, we continue to suggest that investors temper return expectations, maintain a long-term perspective, and adhere to prudent asset allocation with appropriate levels of diversification.