It Aint the Economy, Silly. Its Interest Rates and Trade.
Of course, it is always the economy. I know that.

But the point of my headline is that it isn’t about the economy AT THE MOMENT.

The global economy, AT THE MOMENT, continues to do quite well. I could argue that it is doing better than it has at any other time since the financial crisis.

It is, of course, led by the United States -- the economy grew at a spectacular rate of 4.1% in the second quarter of 2018. While the U.S. growth rate wasn’t the highest in the world, it was the largest change in growth rate of any large economy. That being said, the truth is somewhat more nuanced but gets in the way of a good storyline. Some of the increased growth was expected because of the tax and spending stimulus. But an equally significant change in the second quarter growth rate was the bringing forward of demand due to concerns about trade and tariffs. Soybeans, anyone? All that being said, it was overall a decent quarter nevertheless. There may be some give back in demand in the second half of 2018, but the underlying trends are likely to be still strong.

The situation in Europe and Japan is not too dissimilar. The underlying trends are strong there also, with some inter-quarter and inter-year adjustment for demand trends moving around a bit. But the trend growth rate is solid in both areas, relatively speaking.

The emerging market (EM) economies, similarly, are in relatively stable shape with a few idiosyncratic exceptions like Turkey. While China is slowing a tad, the People’s Bank of China (PBOC) has already started backing away from its tightening policies and the situation in India, Russia, and Brazil is relatively stable, at least in relation to typical EM volatility scales.

So, it ain’t the state of the global economy that is the likely driver for the markets over the next few quarters.

Instead, the markets are likely to be driven by two other factors: a) global monetary policy and b) trade and tariffs.

And there are hopeful signs on both of those fronts, making us sanguine on the outlook for the markets in the near to medium term, the ongoing “correction” in the technology sector notwithstanding.

First, the European Central Bank has already walked back the talk of tightening to 2019 and remains quite open ended even at that.

Second, the Bank of Japan (BOJ), where markets were agog with anticipation of a policy change over the past few weeks, threw cold water on the notion that it was going to move rates up. While it increased the trading range of the 10-year Japanese Government Bonds, it firmly recommitted itself to fighting the disinflationary battle. In other words, no significant change in policy. If it had not turned out the way it did, the market sentiment would be far more vulnerable. Despite all the rumors and purported leaks to the wire services, in the end, it wasn’t about dodging a bullet, instead the BOJ didn’t even fire a bullet.

The story in terms of monetary policy in EM is more nuanced. While some central banks have had to hike rates to defend their currencies, from a steady-state standpoint, inflationary pressures continue to remain relatively subdued in most EM markets, and therefore once the trade related FX pressures ease, the outlook for monetary policy is still quite sanguine. For what it’s worth, the only EM central bank that matters in the global liquidity context, the PBOC, is slowly but surely coming off its credit-growth tightening path, as the Chinese economy starts to slow a tad.

The only large central bank that still remains on the tightening path is the U.S. Federal Reserve. It has been tightening policy for quite some time and given the growth trend in the United States, it is likely to continue tightening at least two times more this year. However, as the yield curve flattens and growth slows down some in the second half, the Fed policy makers are already thinking about future tightening. Powell’s “for now” caveat to gradual rate hikes in his congressional testimony, as well as the Fed’s revisiting the optimal size of its balance sheet this early in the unwind process, tells me they are not fully committed to a path of tightening and are not on the proverbial autopilot.

With the exception of the BOJ statement today, global monetary policy to be sure has been relatively stable lately, and is not the reason why I believe things are changing at the margin.

Instead, the biggest source for optimism in my opinion is the Trump Administration’s newfound flexibility on the trade front.

After almost a half year of relatively belligerent rhetoric, the Administration all of a sudden has started showing a lot more flexibility as mid-term elections get closer.

Behold the walk-back on the trade conflict with Europe last week, pronouncements on the swift progress of NAFTA negotiations with Mexico, and the announcement today of the reopening of trade talks with China. These are all very good signs of progress. It was the trade issue more than anything else that was holding the markets back. Given the solid fundamental growth and earning backdrop, any sign of hope, on this front, will get the markets going again.

The bottom line is that the global economy remains in very good shape, monetary policy is stable, and the trade picture is improving. It all points to a relatively good outlook for the risk markets over the next few quarters.