Markets are showing unwarranted faith in the Federal Reserve

The last time Washington and Beijing locked horns, global equities sold off by about one-fifth. This time, markets have shrugged off the blustery tweets from President Donald Trump, responding to threats of escalation with a somewhat bizarre aplomb.

The 10 per cent tariff currently being charged on $200bn of goods entering the US has been increased to 25 per cent. The remaining $300bn or so of goods that China imports to the US may also face tariffs. These are numbers that will start to have a notable impact on activity in both China and the US.

So why are markets so sanguine? In part it may be seen as rhetorical sabre-rattling, consistent with the narrative Mr Trump set out in his book The Art of the Deal.

More likely the market is taking solace in the fact that the Federal Reserve is showing willingness this time round to pick up the pieces. In the fourth quarter of last year the market had to contend not only with the prospect of a US-China trade war but a hawkish US central bank that seemed to be on autopilot, taking rates up steadily each quarter.

The rhetoric from the Fed has now completely changed. If “restrictive” was the buzzword in the corridors of the central bank in September, it is now “patient”. The market has shifted from expecting two further rate increases this year to rate cuts. Moreover, the Fed has put off its plans to run down its balance sheet. High levels of liquidity in the financial system are here to stay.

The key question now is: can the monetary authorities really counter the potential economic fallout from a hostile political agenda?

The answer is no. The US is at, or very close to, full employment. The unemployment rate is 3.6 per cent, the lowest it has been for almost 50 years. There is no more easy growth to come by. Companies cannot easily pull in a few more staff to meet a new order.

At this point in the cycle, further economic expansion gets trickier. Companies need to invest. They need to equip their current staff with better tools and technology to squeeze a bit more out of them. But given so much geopolitical uncertainty, companies will not have that conviction. During the last round of disagreement between Washington and Beijing, US capital spending plans were hit hard, according to the Duke CFO survey.

Without a revival in capex or productivity, the US will not be able to sustain growth of much more than 1.75 per cent, given that growth in the working age population is now roughly 0.5 per cent. This would represent a marked slowdown from the 3 per cent-plus that the US has experienced for much of the past 18 months.

We have to stop believing that our central banks can generate lasting growth. Central banks merely steal growth — either from the future by tempting people to spend and borrow today, at the expense of the future — or from other parts of the world, by forcing down exchange rates and grabbing a bit of growth from their neighbours.

Central banks manipulate demand. They do not, in the main, generate capacity on the supply side. Supply-side expansion sits more squarely in the realm of government policy — via migration policy, most directly, or more subtly via education, property rights and other initiatives which attract global businesses.

Put simply, if the Fed were to keep pumping demand while political risks are discouraging investment, the result will be unbearable pressure on the labour market and further upward pressure on wages. US corporate profit margins, a huge contributor to the growth in US earnings, will come under pressure.

There are three significant investment implications.

First, expectations of earnings growth for the S&P next year, at 11 per cent, look too high. Historically, this kind of profit growth has required growth in the broader US economy of 2.5 per cent or more. Given current valuations, any downward revision to earnings expectations will restrict gains in the stock market. As such, a more regionally diversified portfolio makes more sense than being heavily skewed to the US.

Second, US growth stocks, which have been the bedrock of the market’s outperformance, might not command such eye-catching multiples in a world in which growth is more modest. The premium currently assigned to growth stocks over value stocks is likely to narrow.

Third, there has been a considerable expansion of leverage in the US corporate sector, taking advantage of the low borrowing costs on offer in both public and private markets. If growth slows, the burden of this debt will feel more onerous. This suggests a focus on quality stocks, companies with good free cash flow and strong balance sheets.

Karen Ward is chief market strategist for EMEA at JPMorgan Asset Management