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Abu Dhabi, UAESaturday 15 December 2018

Equity markets suffer steep losses amid trade and security instability 

Investors are questioning whether the latest falls are merely a correction or a longer-term issue

Traders work on the floor at the closing bell of the Dow Industrial Average at the New York Stock Exchange in New York. At the end of last week, the Dow and the S&P 500 had suffered their biggest weekly drops in two years. Bryan Smith / AFP
Traders work on the floor at the closing bell of the Dow Industrial Average at the New York Stock Exchange in New York. At the end of last week, the Dow and the S&P 500 had suffered their biggest weekly drops in two years. Bryan Smith / AFP

As the Federal Reserve continued on its course of monetary policy normalisation last week, reflecting the current strength of the US economy, other forces were building that might eventually threaten it. Trade tensions were first among these, but there were other scattered events that were also of concern to markets. The week ended with further steep losses in equity markets following those seen in February, making investors question whether such falls are merely a correction or something more fundamental to be worried about.

The Fed’s sixth interest rate hike in the current cycle came as the US economy appears to be in such robust health that few in the market doubted the wisdom of it. The Fed hiked its rate band 25 basis points to 1.50 per cent - 1.75 per cent in a unanimous decision, and retained the dot plot at three hikes for this year. However, the median projection was only a fraction away from rising to four, and the dot plot for 2019 was raised to from two hikes to three.

Furthermore the Federal Open Market Committee looks to tighten monetary policy out to the end of 2020, lifting the rate at the end of that year to 3.4 per cent, from 3.1 per cent previously. The Fed’s statement introduced the view that ‘the economic outlook has strengthened in recent months,’ and highlighted that job gains have been strong. The change in the statement accompanied hikes in the GDP estimates and downward revisions in the unemployment rate forecasts.

Fed chair Jerome Powell was of course asked about the potential for a trade war and the impact this might have on the Fed’s forecasts, but while he acknowledged the risks of retaliation to recent US trade measures, he did not see these yet affecting the economic outlook. That was, however, before the Trump administration imposed further tariffs on up to US$60 billion of Chinese imports, which in turn saw China respond with $3bn of its own tariffs on 128 US products. Although relatively modest, the Chinese response was to the earlier aluminium and steel tariffs with further measures still awaited in reaction to the latest ones.

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Read more from Tim Fox:

Global markets rattled by the prospect of a trade war

Why the Eibor is trading below the Libor

A healthy correction may not be the end result of the global market rout

Trump's politics is hurting the dollar

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Such reactions do not yet amount to an all-out trade war, but they do provide an early warning about how a delicate situation might easily unravel, especially with an impulsive and inexperienced US President now increasingly following his own instincts over key issues such as trade and national security. In the two days following the hike in interest rates, as well as firing off another trade tariffs salvo, Mr Trump replaced his national security adviser with a notorious foreign policy hawk, whose reputation is for confrontation rather than for solving geopolitical situations diplomatically, causing oil prices to shoot up as a result. Trump also unexpectedly threatened to veto a $1.3 trillion spending bill that could have closed down the government again for the third time this year, only to change his mind at the last minute.

Instability was also in evidence closer to home with a prominent resignation from the Trump legal team that is defending the president against the ongoing Mueller enquiry. This enquiry is also taking in more casualties, and not only individuals. Facebook has sold off on the back of revelations exposed by the ongoing investigation causing the tech sector more generally to lose ground, a sector that had been a market leader in the bull market.

At the end of the week, the Dow and the S&P 500 had suffered their biggest weekly drops in two years, having fallen back to levels seen around the time of the volatility-induced February ‘correction’. These losses could hardly be put down to any serious apprehension that the Fed will follow through on its hawkish forecasts, as bond yields also lost ground suggesting that fixed income traders do not believe that interest rates are going to double by the end of 2020. The dollar also found itself weaker as a result.

More worrying is that as the Fed raised interest rates for the sixth time since 2015, the markets do not appear to buy its optimism about the future, but rather they are seeing the seeds of the next downturn in the trade, security and domestic policies they are now observing.

Tim Fox is group chief economist and head of research at Emirates NBD