Investors continued to monitor the tenuous relationship between the U.S. and China, while keeping an eye on where Fed leadership and the dependability of macroeconomic data are headed.
The Discourse Between the U.S. and China
While the implications for global markets remain significant, the U.S.-China relationship has recently moved from the front burner to the back burner. And when we think about the economies of the two biggest kids on the block, it’s natural that there would be some friction, particularly as it relates to trade. Understanding the dynamic between these countries is essential, especially given its effects on trade, economic growth, and market stability.
Over the past two decades, Chinese exports to the U.S. have halved as a percentage of its GDP, dropping from around 7% to 3%. This decline reflects a shift in China’s role from a direct exporter to a supplier of components for U.S. goods, affecting how we perceive the health of U.S.-China trade relations.
Globalization Isn’t Just About the U.S.
Source: Bloomberg, as of 31 March 2025.China and the U.S. keep kicking the can a little further down the road in their attempt to come to a sensible conclusion that doesn’t materially impact trade. Most observers initially felt that China would be in the crosshairs of Trump’s tariff policy. One of the things we are seeing is that the administration is sort of slow walking the engagement with China by engaging with some of its other trade partners. Perhaps an underappreciated element of China’s exports over the last decade is its exports to Vietnam, Cambodia, Mexico, and Canada, which have grown at about twice the rate of China’s exports to the rest of the world. This has occurred as China has shifted to being more of a supplier of components of things that get sent to the U.S., rather than assembling everything in the U.S.
China’s Economic Resilience
Despite the tensions, the Chinese economy demonstrated economic strength in the first half of the year, driven by preemptive exports as companies rushed to avoid potential tariffs.
GDP Growth in China
Source: BloombergThis has raised questions about the confidence level of both governments: Is the U.S. waiting for a more favorable climate to engage? Or does China feel secure enough to withstand further strains? One really impressive thing is China’s innovation around semiconductors. And leading Chinese semiconductor companies have made a lot of progress on AI chips, as well as other more leading-edge chips.
A Focus on the Fed
We’re hearing from clients who are thinking about adding more interest rate sensitivity to their fixed income portfolios. A lot of that is based on the belief that the Fed is going to start cutting rates more aggressively. Futures projections are predicting more than 50 basis points of rate cuts through year-end. And a probability of more than 25 basis points of cuts in September. And there’s a view that when the Fed cuts the front end, the whole curve might come down. We’ve parsed through a lot of the data, and if you go back to the most recent cuts from September through December of last year, interest rates actually rose across the curve from 2s to 30s.
Implied Fed funds Target (dot plot)
And the second part of this is inflation protection. Overall, inflation is pretty solid. Still pretty sticky in the mid 2% range. Core inflation could accelerate or at least remain elevated as well at closer to 3%. So, how much can the Fed lower, and what are investors willing to tolerate at the front end of the curve? And, if the Treasury secretary wants real yields to be negative at the front end of the curve again, will private investors be willing to tolerate that again? The truth is that the Fed has a dual mandate, but most central banks around the world don’t have that dual mandate of full employment and price stability.
A 4.2% unemployment rate is identical to what it was last July, but it’s higher than the 3.5% level of July 2023. When it comes to price stability, the Fed did a great job of bringing inflation down from a 40-year high. But as you noted, it’s gotten pretty sticky, particularly when we look at services. The Trump administration would like to see rates lower because there’s a belief that it’s going to drive stronger economic activity.
Bond Market Implications
Fixed income investors have essentially two risks to be aware of when they put capital to work, and that’s credit risk and interest rate risk. Interest rate risk is the risk that rates rise and the value of the bonds goes down. Credit risk naturally has the potential for default or deterioration in the economy or the business, and the credit spread widens, which leads to a lower price.
We generally care about earnings and whether there’s earnings upside for bonds. We might care about whether the economy is working or weakening. And there’s downside risk. The bond market has reacted cautiously to economic indicators. Despite revisions in job growth data, credit spreads have remained tight, suggesting that investors do not foresee an imminent economic downturn. However, the challenge lies in determining whether the Fed’s actions will lead to a meaningful shift in interest rates, particularly in light of persistent inflation.
Inflation continues to be a significant concern. Although the Fed has made strides in reducing inflation from historical highs, core inflation remains sticky, particularly in the services sector. Investors should monitor how these inflationary pressures could influence the Fed’s monetary policy and subsequently affect interest rates.
The Role of Data Reliability
Investors must also consider how data reliability influences decision-making, and how the Fed and companies might make decisions in the current environment. Recent downward revisions in non-farm payroll data have raised concerns about economic health and the Federal Reserve’s policies. While confidence in U.S. government data remains relatively strong, ongoing revisions and inconsistencies could signal underlying economic challenges, although there have always been revisions to data over time.
From a longer-term standpoint, we still have strong confidence in government data, whether it’s the Bureau of Labor Statistics or the Bureau of Economic Analysis. But it is important to continue to evaluate the strength of that data, because we’re making important decisions from either the administration, the Fed, or as investors.
Strategic Considerations for Investors
In light of these factors, investors should consider the following:
- Diversification: Maintain a diversified portfolio to mitigate risks associated with geopolitical tensions and economic fluctuations.
- Fixed Income Opportunities: Explore opportunities in the fixed income market, especially in securitized assets that may offer more attractive valuations compared to corporate bonds.
- Market Monitoring: Stay informed about the U.S.-China trade relationship and its potential impacts on global supply chains and economic health.
Conclusion
The interplay between the U.S.-China relationship, macro dynamics, and data reliability presents both challenges and opportunities for investors. By staying informed and adaptable, active investors can better navigate this complex landscape, positioning themselves for potential growth while managing risks effectively.
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