The great trade update
Markets fell over 600 points on Monday as the weekend's negotiations yielded no substantive update. The increase from 10% to 25% on $200 billion of imports from China was implemented, though the markets seem to be trading as if there is short term volatility concern more than the fear of a systemic and sort of permanent trade conflict.
Ultimately I believe this either ends with:
(a) A short term resolution as these talks and negotiations continue whereby China accepts American demands for enforcement mechanisms and the U.S. lifts the recent escalation, OR
(b) This continues back and forth for several months until the cumulative pain causes one or both sides to break (this is the option which would extend bi-directional volatility for quite a while), OR
(c) President Trump decides to walk away from negotiations and take his chances in 2020
I believe Option C is the least likely, but I will say that it is entirely possible the Chinese decide to do the same if they believe he is likely to lose. Right now they clearly do not, for there is no real scenario where they would go down this path if they thought they were assured a better deal in 18 months if they could just wait it out.
So that leaves either option A or option B, and this week seems to be reinforcing the idea that there is a 50% chance of option A, likely after the G20 meeting with President Xi and President Trump, and a 50% chance of option B. That sounds right to me.
My real fear
The short term impact of these particular tariffs is not the biggest economic threat I am worried about. I do believe the economic analysis that for every two months, these new tariffs represent a 0.1% hit to GDP growth. If somehow this escalates to tariffs on all $500 billion of imports, I would suggest that a recession in short order would be nearly unavoidable. I would substantially doubt that scenario's likelihood. But I do fear that some believe the U.S.'s strong economy gives us "wiggle room" to force a trade war. It does not. A large amount of our GDP growth has come from inventories, not sustainable quarter over quarter.
Furthermore, the business investment needed to sustain and grow GDP growth will not only not expand in a prolonged trade war, but will contract. The economic data does not offer enough margin to offset this. Uncertainty is a catastrophe for business investment, and business investment is the need of the hour.
Please note below the spoke in Capex when President Trump was elected, and tax reform was enacted, and then the collapse in Capex when the trade war was launched.
Ironically, Capex increased intentions ticked up to 4.2% in March (for full-year 2019) vs. 3.7% in February. Capital Goods orders pushed up budgets in the Industrial space 8.4%. A good amount of the data I study relentlessly here picked up in the very short term in March/April. My fear is this momentum will not get the time to really build if the trade war creates the suppression of confidence I suspect it will.
The pickle in all of this
I actually believe two things at once, and reconciling those two things is the real challenge for an asset allocator. I do believe that this will stay in flux for some time, elevating short term market volatility to a point of discomfort. And yet, I do believe the final deal will be a positive in investment markets. Getting additionally defensive now risks missing that second outcome. Getting additionally opportunistic now exposes one to the enhanced short term volatility of that first scenario. Bracing for both is not an exact science. I believe we have intelligently positioned client portfolios with the balance needed for this very tension.
How bad could it get economically?
Putting aside "my real fear" (see above), the basic math of the impact to GDP is reasonably measurable. The length of time matters, but I believe the present escalation (stage 3 below) does represent a .6-.7% negative impact on American economic growth. And should they actually proceed with a 25% tariff on essentially all Chinese imports, I believe it will take away over 1.4% of GDP growth (about half of the growth anticipated for full-year 2019). It is hard to picture a scenario where the next step after such a contraction would not be a recession.
But what if China goes nuclear??
No, I don't mean firing nuclear missiles at us (does anyone know if nuclear wars are also easy to win?), but rather what financial minds are calling the "nuclear option" - which is the idea that China uses their possession of $1.2 trillion of U.S. Treasury debt as leverage in this trade battle. With an H/T to Strategas Research, here are five reasons why the fear of China dumping Treasury debt are not totally realistic:
(1) If they sell Treasuries, what exactly are they going to buy? Whether it be Euro or Yen, they invite even greater problems with significant trading partners
(2) If they sell Treasuries, they may raise interest rates a bit, but then they invite other global buyers to come in, which undoes the damage to the U.S. rate market, and yet created losses for China as they sell at lower bond prices
(3) China's financial system is leveraged to the hilt. The collateral for a huge amount of that leverage is - you guessed it - their holdings of $1.2 trillion of U.S. Treasuries. They cannot impair their own collateral.
(4) It could trigger a flight out of emerging markets which creates a liquidity squeeze and hurts huge trading partners of China (with China bearing that blame)
(5) It would aid Japan, potentially even capitalizing Japan's re-militarization (one of China's most significant fears)
The so-called nuclear option has always missed the real fact of the matter when you start talking about debt levels this big: The person who owes the money has more leverage than the person owed the money when the amount of money gets high enough. $1.2 trillion is high enough.
In the meantime, who pays?
U.S. companies that import products from China pay the tariffs. They, of course, pass on that cost to their customers (and employees). Have you ever wondered why oil prices go up X, but your cost at the gas pump goes up more than X? Most studies indicate that the cost of tariffs is passed on to consumers at a rate greater than 100% of the cost of the tariffs themselves. Ultimately stress in the sale of goods impacts workers too - as warehousing, marketing, distribution, sales, transportation, and fulfillment businesses are impacted.
The Center for Economic Policy Research anticipates a $1.4 billion impact per month in consumer spending alone from the present tariffs, not counting additional escalations.
China's Industrial Production grew 5.4% in April; it's slowest YOY growth in 17 years. There is no question that China is vulnerable, economically weaker than the United States, and in need of its largest trading partner to be freely and happily buying from them. But we should be clear - saying China is suffering worse than us says nothing about our suffering. Deals not getting done; farmers losing revenue; consumer prices going higher; suppressed business investment (see above) - there is plenty of pain being felt and to be felt, and while political tweet spin is common, we should not be coy about this: No one is winning.
State of the market
Whether it be valuation, sentiment, liquidity, or earnings, the accurate measurement of market conditions is Neutral. Things are not screamingly cheap, but they are not expensive, and the trade war has knocked valuations down a tad (just a tad, for now). Sentiment is not bad enough for the contrarian in us to feel super jazzed, but sentiment is not positive either. Earnings are positive, but their outperformance vs. the excessively negative expectation for Q1 has been priced in. Bottom line - a sort of balanced, neutral positioning, not aggressively expecting melt-up conditions, but not placed for panic or doom either, is the right place to be.
Speaking of sentiment and valuation ...
High Yield bond spreads sit at around 400 basis points right now. We have long argued that 250-350 suggests an unhealthy complacency about risk (risk is priced too high), and 550+ suggests real bargains in risk assets. This ~400 range (high yield bonds delivering yields 4% higher than comparable Treasury bonds) is, again, right in that "neutral" spot - well-priced, not excessive, not cheap.
Politics & Money: Beltway Bulls and Bears
- The major political story in markets is obviously U.S./China trade talks, yet I have thoroughly covered that already. The specifically political comment I will make on all that is transpiring: There is a point at which "tough on China" (beneficial to President Trump politically) could convert to "hurting the economy" (not good for President Trump politically) - and I mean that in terms of how voters perceive it all. I am confident that, so far, it has been more beneficial to him politically than not. I am further convinced that the point at which all of a sudden, the narrative changes can come very unexpectedly.
- Now, do you want some evidence that even President Trump really does, in his heart of hearts, know the risk of what is happening in our economy as a result of the trade and tariff tensions? I suspect as a direct result of the tensions already embedded in the China conflict; President Trump punted on Wednesday the issue of tariffs on European auto imports. I am skeptical that the eventual deal will open European markets to as many U.S. products as we are hoping (particularly on the agriculture side), but it does appear quite clear that the draconian idea of an auto tariff is off the table.
Chart of the Week
This week's chart highlights the advantage of being a U.S.-centric company in Q1 vs. dependent on global sales. In both revenue growth and especially earnings growth, the more domestic the business, the better the growth results. This is a by-product of two things that should be understood: (1) The impact of a stronger dollar, and (2) The more fertile economic soil in the U.S. vs. Europe and Asia.
Quote of the Week
“Example is the school of mankind, and he will learn at no other.”
-- Edmund Burke