Per Stirling Capital Outlook – May 2019
American author Mark Twain observed that, “History does not repeat itself, but it oftentimes rhymes”. For evidence of just how insightful this perspective is, one needs to look no further than the Winter 1982 edition of Foreign Affairs Magazine, which noted that:
“President Reagan won his office in part because he convinced the electorate that the Soviets had hoodwinked all Administrations of the last decade. He proposed to reverse the unfavorable trend of U.S.-Soviet power relations and, quite simply, to ‘stand up to the Russians’.”
If you were to substitute the words Soviets, Reagan, power and Russians with the words Chinese, Trump, economic, and China, this statement becomes virtually inseparable from current headlines.
Indeed, just as was the case almost forty years ago, when President Reagan used America’s economic might to break the back of the Soviet economy, President Trump is turning to economic warfare in an effort to force China to abandon its predatory practices like intellectual property theft, forced technology transfers, and forced joint ventures, and to begin acting as a responsible and law-abiding member of the global economic community.
Reagan’s weapon of choice was an arms race, which forced the Kremlin to spend beyond the U.S.S.R.’s economic means, as they endeavored to keep pace with America’s growing military might. By the mid-1980s, the Soviet Union was committing an estimated 70% of its industrial capacity and 33% of its total economic output to the military. While the Russian government continues to deny the cause and effect aspects of Reagan’s economic strategy, the prevailing opinion is that excessive military spending overwhelmed the Soviet economy and led to the ultimate dissolution of the Soviet Union.
President Trump has selected a different economic weapon of choice–tariffs, which he has continued to portray as a cost borne by foreign exporters, despite the fact that the higher associated costs are actually initially borne by domestic companies, and probably ultimately passed on to the American consumer in the form of higher retail prices.
If companies are able to pass through the cost of tariffs, it should help to catalyze the long-awaited return of at least modest inflation. If they cannot, then tariffs are likely to serve as an ongoing headwind in the face of American corporate profits and, as a consequence, equity prices.
The longer that tariffs last, the more damage that they will cause to the global economy. According to estimates from Strategas Research, existing tariffs will reduce U.S. economic growth by 0.1% for every two months that they are in place.
According to CNBC, the combined $72 billion in revenue derived from the current level of tariffs represents one of the biggest tax increases since 1993 (barely exceeded by the revenue raised in the fourth year of the Affordable Care Act).
However, unlike income taxes, tariffs affect virtually every American consumer. Indeed, the Penn-Wharton Budget Model estimates that the existing level of tariffs will increase costs to the median U.S. household (with earnings of $61,000) by about $500 to $550 per year.
Of course, the economic impact of the intensifying trade war between the world’s two largest economies will ultimately depend on how long it lasts and how aggressive the two sides become in regard to tactics. Oxford Economics has produced some of the more in-depth research on this topic.
According to their findings, existing tariffs are likely to reduce U.S. economic growth (GDP) by 0.3% in 2020, while slowing China’s growth rate by 0.8%. In dollar terms, that translates to a cost to the domestic economy of around $29 billion by 2020. Importantly, the impact is expected to be global in nature, and shave 0.3% ($105 billion) from global growth by 2020.
Oxford Economics estimated that the next logical escalation, with President Trump placing 25% tariffs on all Chinese goods and Beijing retaliating proportionately, would cause U.S. economic growth to decline by around 0.5% ($45 billion) by 2020, as compared to its pre-trade war potential. They estimate that China’s economic growth will be reduced by around 1.3% in 2020, and for global economic growth to be reduced by 0.5%.
Under the “extreme scenario” of an aggressive and multilateral trade war, Oxford Economics would expect an American recession later this year, a 2.5% reduction in Chinese growth, a significant contraction (-1.5%) in Europe and Japan, and a 1.7% reduction in global economic growth as a whole.
There is no doubt that it is in the best economic interest of the U.S. and Chinese economies if both countries can come to terms in regard to trade and the protection of intellectual property. Moreover, with China currently accounting for roughly one-third of the world’s economic growth, the economic ramifications of the current trade war are almost certain to be very global in nature.
As was well-described in a just-released report from DataTrek Research, “the U.S. and China have blundered into a minefield …The risk of a U.S. recession is rising sharply and quickly”.
To be clear, we do believe that common economic interests will ultimately motivate the world’s two largest economies to form a compromise agreement, and that capital and currency markets are ultimately likely to play an important role in forcing the two sides towards that compromise. In China’s case, pressure is likely to come from capital flight and the choking off of foreign direct investment. In the U.S., we would not be surprised to see stock market losses (in the case of a prolonged trade war) force President Trump to change his strategy, just as they did with the Federal Reserve around the turn of the year.
That said, there is a growing, and we think very reasonable perception, that it may now be in the best interest of both President Trump and President Xi Jinping to prolong the trade war for political gains. Indeed, we are growing somewhat concerned that, if this trend continues, a trade agreement could potentially be delayed even beyond the November 2020 U.S. elections, which would potentially be quite negative for equities. As we will discuss, the outlook for the bond markets is much more difficult to discern.
From President Trump’s perspective, he has found in the trade war a very populist issue that not only appeals to his base (aside from farmers, who are serving as the sacrificial lamb in this trade war), but also has broad appeal on both sides of the aisle, albeit for different reasons. As a result, his popularity is at new highs and the wager-based prediction markets are significantly increasing the odds of a Trump reelection, albeit still at only 47%.
Now that Joe Biden, who has an existing and arguably milquetoast track record dealing with China as part of the Obama administration, has established himself as the clear front-runner as the Democratic presidential candidate, a continuing trade war seems to serve Trump particularly well. Indeed, President Trump is already actively positioning Joe Biden (and all Democrats) as being too weak to negotiate with China.
By this logic, any successful conclusion of a trade agreement with China would eliminate one of President Trump’s primary arguments for why he needs to be reelected.
Moreover, if he successfully concludes a trade deal, each and every element of it can be criticized by the Democrats in the 2020 campaign. In the current state, there are so many conflicting reports from the two sides that it is difficult to identify any specific details that can be criticized. This logic also suggests that Trump can be more flexible in negotiating a deal after the elections, as he won’t need to worry about being perceived as soft when he makes some of the concessions that will ultimately be necessary in order for both sides to come to terms.
Of note, while President Trump has probably used the stock market as a report card on his administration more than any of his predecessors, and has frequently used tweets and press conferences to rally the equity markets whenever prices are in decline, there are numerous indications that trade is the one area where the “Trump put” does not apply, as he considers trade to be even more important than the financial markets. It was one of the cornerstones of his campaign.
From the Chinese perspective, while President Xi Jinping does not face reelection, he still, at least in theory, serves at the pleasure of the National People’s Congress, and he is expected to implement and successfully meet the vision and objectives of that body. A major stumbling block to an agreement is that China has laid out a very ambitious set of economic objectives, and that the White House is demanding a variety of changes that will make the achievement of those ambitious goals almost impossible.
“China 2025” is China’s grand master plan to transition its economy from being the world’s sweat shop, cranking out inexpensive, low quality goods, to a global leader in technology, providing high quality, sophisticated goods to the world. Through their “Belt and Road” initiative, they are planning to concentrate specifically on consumer markets in Europe, the Middle East and Central Asia through trade and investments in infrastructure.
President Xi Jinping currently has no incentive to give in to U.S. demands, and there is a growing belief among some political pundits that President Trump’s agenda is actually best advanced by causing enough economic damage to force China to reintroduce massive stimulus and the Federal Reserve to cut interest rates, each of which would likely stimulate the economy and catalyze a stock market rally just in time for the 2020 elections.
In addition, since President Trump campaigned on the idea of standing up to the Chinese economic threat, it is also likely to be politically advantageous for him to be seen doing exactly what he promised to do, as the election approaches.
In the meantime, both sides seem to be hunkering down for what looks increasingly like it is going to be a prolonged and economically damaging conflict. President Trump continues to accuse China of negotiating in bad faith, after they reportedly walked away from a trade agreement with the United States (a deal which China denies ever existed). To further inflame tensions, the U.S. just sent a navy warship through disputed territory in the South China Sea, and President Trump took steps aimed at crippling one of China’s most important companies, Huawei Technologies, by depriving it of critically-important American-made components, although he later delayed the implementation of some of those restrictions.
We also think it noteworthy that, within just a matter of hours, President Trump announced that he was postponing a decision on the imposition of automobile tariffs for six months (aimed at the European Union and Japan ) and that a deal had been reached to drop the aluminum and steel tariffs (and all related lawsuits) between the U.S., Canada, and Mexico. President Trump is a huge proponent of tariffs, and it does not make sense to us that he would have taken either of these steps if he was not actively reducing the trade war down to only one front, in anticipation of a prolonged trade battle with China.
China, on the other hand, is ramping up nationalist sentiment, and portraying the United States as just yet another colonial power trying to take advantage of China, in an attempt to renew what state-sponsored media is calling China’s “century of humiliation”, when imperialist powers took advantage of a weak China during the 19th and 20th centuries.
As was just noted by the People’s Daily, a newspaper controlled by the Chinese ruling Communist Party, “At no time will China forfeit the country’s respect, and no one should expect China to swallow bitter fruit that harms its core interests”. Moreover, the previously banned term “trade war” is now being splashed all over Chinese state-sponsored media.
According to Liu He, China’s vice premier and chief negotiator in the trade talks, China’s demands are a removal of U.S. tariffs, better terms of procurement, and “balanced text” in the trade agreement. “The text must be balanced and expressed in terms that are acceptable to the Chinese people and do not undermine the sovereignty and dignity of the country”.
Building up nationalist sentiment is very important to China, as they can not compete with the U.S. on a tariff basis, because of the huge trade imbalance between the two countries. As a result, China will need to rely upon less traditional trade tools, like encouraging Chinese consumers to boycott American company products altogether, and those tools are most effective when reinforced by a nationalistic fervor.
Korean War movies are being shown in theaters across China and, over the weekend, Chinese television aired three anti-American movies in prime time. There is reportedly a growing and publicly-supported belief that the U.S. is not pursuing fair trade, but is instead pursuing a campaign to retard and delay China’s development as a major economic force. From our perspective, that perspective is not without basis.
However, China may need to remain at least somewhat measured in its responses to U.S. pressure, as they do not want to scare away foreign direct investment, which they still depend on as part of the China 2025 Initiative. That said, China can counter U.S. tariffs in a variety of ways, including by debasing its currency, by making it very difficult for American companies to operate in China, by disrupting American supply chains, and by depriving the U.S. of rare-earth minerals (80-90% of which come from China), which are a critical component in everything from smart phones to electric cars.
China’s so-called “nuclear option”, as the largest foreign holder of U.S. Treasuries, is to drive U.S. rates much higher by selling much of their more than $1.1 trillion of U.S. government debt. Indeed, the fact that China has cut its Treasury holdings to the lowest level in two years (a year-over-year decline of -5.6% or $67.2 billion) is anything but coincidental. However, we have significant doubts that the Chinese will resort to such a draconian strategy, as it would devalue the dollar, diminish the value of their foreign currency reserves, and slow the global economy, each of which would likely hurt China more than the U.S.
Frankly, as a major exporter, China receives massive payments in foreign currency on a regular basis that must be invested somewhere, and Treasuries are simply their best option, particularly since the other major alternatives (European and Japanese sovereigns) currently offer negative yields. This accounts for the very close correlation between China’s foreign currency reserves and its holdings of Treasuries, which is illustrated above. Of note, Belgium frequently acts as China’s proxy when purchasing Treasury debt, while holding little U.S. debt for their own account, which explains why Chinese and Belgian holdings are combined in the aforementioned chart.
That is not to suggest that bonds are immune to trade-related risks, as tariffs are likely to boost inflation, which is a negative for bonds. At the same time, the trade conflict is likely to slow the global economy, which should be bullish for debt investments and, in addition, the Federal Reserve is in the process of buying huge quantities of Treasury debt, which they are using to replace the mortgage-backed (MBS) debt on their balance sheet as the MBS matures, and this should help to offset any declines in the Chinese buying of Treasury securities.
Unfortunately, we do not believe that either the American consumer or the global equity markets will be similarly protected if, as we suspect, the U.S./China trade conflict continues over the foreseeable future. Indeed, unless there is significant progress made by the conclusion of next month’s G-20 meeting, when Trump and Xi Jinping are expected to meet, we expect for President Trump to impose tariffs on the remaining $300 billion of Chinese imports that are not yet subject to tariffs.
However, unlike the first $200 billion of tariffs that targeted primarily heavy machinery and industrial equipment, the next tranche of tariffs will hit consumer products, which will have a very tangible impact on the American consumer. Indeed, in that instance, research by the economic consulting firm Trade Partnership Worldwide anticipates a cost of living increase for the average American family of four of up to $2,300 per year.
Ironically, this trade conflict may ultimately return to the place from whence it came, which was the building of a united front to isolate and confront China. While the President backed out of the Trans-Pacific Partnership, which history may judge as the biggest blunder of his presidency, there is a new multilateral initiative underway involving the U.S., the European Union and Japan (and potentially Australia, Canada, Norway and Taiwan) to force curbs on state-sponsored and/or state-supported industries (i.e. China).
In the meantime, we are witnessing what is quite possibly the most binary and enigmatic market environment that we have ever seen in our decades of experience. Markets are not being driven by earnings, interest rates and economic data as much as they are by Presidential tweets and “tape bombs”, which can move markets dramatically in either direction, and without warning.
It is almost never a good thing for investors when the world’s two largest economies are actively trying to impose economic pain on one another, and the equity markets are currently further challenged by significant technical resistance just above current prices. While the next White House tweet could just as easily send the markets much higher as send them lower, the current level of uncertainty and unknowability suggests to us that it may be only prudent to lower levels of portfolio risk, as the markets await additional clarity.