What’s the big picture?
At Christmas 2018, markets were in poor shape, and sentiment was negative. In the New Year, with the Fed capitulating to calls from the White House for looser monetary policy and for more liquidity, markets rallied. But momentum has slackened over the last month. The reason is very clearly the escalation in tension between the USA and China around trade and tariffs. This is affecting perceptions of future economic growth and therefore share valuations. Will equities soon be reporting lower earnings? These doubts create a knock on effect in the bond market where China, of course, has plenty of muscle. If global trade is slowed by protectionism, inflation, which is not generally expected to be a factor, could yet spring a surprise, and could force central bankers to push up rates. Let’s look at each of these aspects in some greater detail.
Trade war bites
Earlier this month Trump increased pressure on China by outlining a 25% tariff on a further $300bn of Chinese imports. In addition, Huawei, the global Chinese telecommunications company, was barred by Google from using its Android software after the White House placed the company on its banned entity list. The Chinese responded swiftly. Beijing saying they would raise tariffs on $60bn of US goods.
Stocks fell in response with the S&P 500 suffering its worst day of the year, falling 2.4%. Credit spreads widen and bond yields fell, while volatility indices such as the VIX reflected the “risk off” reaction.
Economic impact
Markets flinched but was this reaction predicated on fundamentals? Trump’s trade policy is designed to shift consumption preferences away from Chinese goods, boosting consumption of domestic goods and safeguarding jobs in industries such as steel. Analysis by Peterson Institute found US tariffs on imported steel have indeed saved 8,700 jobs however the cost of this to the economy was a staggering $650,000 per job. Economic theory teaches that protectionism is bad for the whole economy. Principally it leads to inefficient allocation of resources and translates into higher inflation and lower corporate earnings, the exact split dependant on the pricing power of the industry and the elasticity of demand.
Source FT.com (May 2019)
As the graph above highlights, the consumer has already been hurt noticeably by current tariffs and as the tariff coverage increases, the impact will too. Indeed, the Fed estimates the US tariffs on Chinese imports will cost the typical US household $800 a year.
Equally there will be a portion of the economic loss absorbed by companies with the effect of reduced margins and profit. There are also those US companies exporting to China hurt by retaliatory measures. Indeed the price of soya beans, a key US export, has fallen to levels not seen since before the financial crisis. This is not a sector specific story, rather a large cap one, with companies as diverse as Apple and Caterpillar impacted.
Either directly through higher costs, or indirectly through reduced demand seen by domestic producers and foreign exporters, there is likely to be a headwind on corporate earnings that will filter through to all US companies, not just Chinese exporters.
Source FT.com (May 2019)
The current tariffs have already had an impact on the global economy. Indeed, global trade has shrunk more than any time since the financial crisis as illustrated above. Bloomberg (see below) also highlight the possible impact on Chinese, US and global GDP from current tariffs (lighter tones), alongside what the impact might be of a potential 25% bilateral tariff on all trade between the two countries (darker tones). As can be seen, a prolonged and exacerbated trade war could materially impact global growth and as such the valuation of assets.
Source Bloomberg.com (May 2019)
While the impact on GDP seems worse for China, as a proportion of GDP growth the effect may end up being relatively less harmful. Indeed, US exports to China were down 30% year on year in Q1 while Chinese exports to the US were down just 9%. This was perhaps helped by an 8% depreciation in the Chinese currency against the dollar over the past year. The Q1 drop in bilateral trade was worth a combined $25bn or 0.5% of global trade, albeit that this is possibly exacerbated by the stockpiling prior to the current tariffs coming into force.
Bond market implications
There is also an impact in the bond market. Over the last month we have seen a further reduction in yields across the US Treasury curve, the 10yr yield down at levels not seen since 2017. This is a reflection of more than one economic driver.
Source FT.com (May 2019)
Firstly, it highlights the markets belief that trade wars will be detrimental to the US and global economic health. This can be further extrapolated from the inversion of the yield curve, where the 3 month yield now offers a premium to the 10 year – historically a strong predictor of impending US recession. Secondly Treasury bond futures now imply a 75% chance of a cut in rates by the Fed before year end, up from 58% previously – a sign the market believes the US will suffer in the short term at the very least. Lastly, falling yields are a function of the “risk off” effect as investors move capital from equities to the perceived safety of US government debt.
Interestingly we saw the Chinese liquidate $20bn of US Treasury holdings in March, an amount not accounted by normal market flows. If trade tensions deteriorate further their large holding of US debt could be used as another tool to retaliate putting pressure on yields to go up instead.
Sting in the tail
A tail risk to the current scenario exists in the form of potential inflation. Central banks around the world have talked down its impact to retain the current low interest rate environment and support growth. Indeed as discussed earlier it was the pause in interest rate rises from the Fed (the only major central bank to initiate meaningful rate rises), that led to the rally in asset prices this year. The low inflationary rhetoric may not however be very credible. As the Fixed Income team at Liontrust highlight in the chart below, G7 CPI is at a normal level for the past 25 years, while central banks continue to depress interest rates. An output of prolonged protectionism will be an increase in cost push inflation. With the current disparity between bond yields and inflation relative to history, it may not take much to push inflation up to levels which force the hand of central bankers. Any increase in interest rates given the current levels of debt in the global economy could be the final straw that prompts a recession.
Source Liontrust (May 2019)
Summary
A pause in the tightening of monetary policy from the Fed has driven the “risk on” environment that boosted asset prices this year. An escalation of trade tensions between the US and China has however put the brakes on. While on the face of it central bank liquidity has a larger impact on the markets direction, this trade dispute could have a meaningful impact on global trade and economic growth. This will hurt the consumer through inflationary pressures, will depress earnings and if the bond market is to be believed is leading us towards the next recession. All is not lost, but attention is required as the scenario unfolds.
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