09/13/2019

U.S. – China Trade War: Continued Negotiations, Escalation or New Deal

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So much for “Trade wars are good, and easy to win.” Trade talks between the U.S. and China are erratic and, so far, unproductive. Larry Kudlow may have revealed the tenor of the negotiations by saying, “The U.S. may never reach a trade deal with China.” His observation suggests that open-ended negotiations may last a long time. Alternatively, the recent tariff hikes by both countries, combined with President Trump’s “order” for U.S. companies to “immediately start looking for an alternative to China,” suggest instead that the trade war could easily escalate. Meanwhile, U.S. political pressures for resolution before 2020 elections and China’s slowing economy create hope that the situation may unfold in a more positive way. Whether the outcome ultimately involves extended negotiations, creates a dangerous escalation, or produces a new deal, the global economy after trade talks will differ from where it was before tariffs begin back in 2018.

Continued Negotiations

Things are about to get worse. The consequences of tariffs will be more visible in the next 12 months because Trump saved the most important items until last. The tariffs applied in 2018 to $250 billion of intermediate goods had minimal impact on consumer prices, as companies absorbed many of them. Planned tariffs for September and December of this year will be more visible to consumers, however. The September tariffs affect apparel, shoes, and TV screens, while those postponed until December 15th include iPhones, toys, and video game consoles. JP Morgan expects that the tariffs will cost U.S. shoppers an extra $1000 per year (including those in September and planned for December). That amount will increase when Trump implements the 5 percent tariff increase announced on August 23rd; this will be applied to all announced tariffs, increasing 25 percent tariffs to 30 percent and 10 percent tariffs to 15 percent.

The tariffs apply directly to Chinese goods, but we expect they will also indirectly affect the cost imports from other countries. Non-Chinese companies exporting to the U.S. can increase prices and still compete with Chinese goods, and consumers will pay higher prices as a result. The levies will also act as a headwind to corporate profits, since higher import costs should reduce profit margins. Retaliatory tariffs in China will reduce U.S. competitiveness there, and we are hearing companies like Home Depot and Kohl’s guiding earnings expectations lower to reflect the impact of this new trade war.

Dragging out the ongoing negotiations means that scheduled tariffs will further reduce corporate profits, increase consumer prices, reduce business investment, and slow economic growth. The importance of the situation has not gone unnoticed, as investors’ collective response to each volley in the trade war has sent a clear message in the form of plummeting stock prices and lower bond yields. Recent discussions of a reduction in the payroll tax and indexing capital-gains taxes are evidence that the administration knows of the potential damage to the economy and that such fiscal countermeasures may be needed to maintain reasonable economic growth. Easier monetary policy could also provide a stimulus, but the Fed cannot assure it. Stagflation – higher consumer prices (inflation) coupled with slower economic growth – is not an easy situation for the Fed to cure. Even if the trade conflict shows signs of improvement, the consequences of tariffs already in place will impact prices, profits, and growth.

Escalation

The unpleasant nature of the trade talks could shift to disaster, as additional tariffs will amplify the consequences of those already scheduled and increase the chances of global recession. Beyond tariffs, other forms of escalation can be worse. For instance, a repeat of Beijing’s 33 percent overnight currency devaluation that took place in 1989 would destabilize currency markets globally. The Trump administration could then respond with a U.S. dollar devaluation, and, the EU – with exports worth 40 percent of its GDP – would have little choice but to devalue the Euro to remain competitive. Global turmoil could result. Hopefully, cooler heads will prevail.

Escalation can also involve actions directed at specific markets, companies, or materials. An obvious example is that China could withhold rare earth elements from the United States. The U.S. largely depends on China for these metals that are vital for producing catalytic converters, advanced engines and turbines, specialty glass for display screens, and hi-tech consumer products. Similarly, the U.S. could target specific restrictions on companies like Huawei, China could respond with comparable handcuffs on companies like Apple, and the net effect would be to create global collateral damage.

New Deal

A new trade agreement would be better than other options. It could avoid the disaster of escalation and mitigate the adverse consequences of scheduled tariffs. But negotiating a new deal would not be fast or easy. The key issues of preserving intellectual property and allowing foreign companies to compete in China with fewer restrictions will set precedents for how China treats companies from other countries. For over a year, investors have relied on the hope that a trade agreement is of mutual benefit to the two largest economies in the world. Perhaps the pressure of upcoming U.S. elections and slowing growth in China will instigate the compromises necessary to reach such an agreement. Investors will celebrate this outcome, as avoiding the other alternatives of negotiations without resolution or escalating the conflict would be a significant victory, and equity prices should move higher than in either of those two scenarios.

At the same time, a new trade agreement is not a panacea for economic growth, and investors should be mindful of this notion. Corporate confidence will improve along with less restricted terms of trade with China, but it may not justify additional business investment. Perception surrounding trade policy cannot be expected to immediately revert to the more peaceful interpretation of years past: U.S. auto tariffs on imports from the European Union will still be a concern, skepticism about the business environment in China will be ongoing, and the uncertainty of U.S. trade policy will remain elevated from levels before the tariffs began in 2018.

Aside from the trade war, which has garnered most financial headlines in recent months, other concerns that dampen business investment continue to develop. North Korea remains unpredictable. Brexit looks like an ugly divorce. Iran is active in the Straits of Hormuz. Political differences between Japan and South Korea are translating into economic concerns. A new trade agreement with China would avoid a worst-case situation; however, it will not assure investors of years of uninterrupted 3-percent GDP growth or reposition the U.S. economy back to where it was earlier in its post-Crisis recovery.

Overall, the trade conflict with China is unlikely to produce an outcome that rewards additional portfolio risk. The potential scenarios of extended talks, escalation, or a compromise agreement suggest continued uncertainty, global disaster, or limited upside, respectively. With little reward for the ideal resolution to the trade conflict, and other concerns waiting their turn to take center stage, investors may want to reposition some part of their portfolios to address a potential increase in volatility.

Synergy’s Portfolio Considerations

  1. We have an allocation to emerging market debt that may be helpful in coming quarters, as a slowdown in global growth pressures central banks to reduce rates. U.S. rates have already moved lower in anticipation of additional Fed rate cuts. Emerging market debt offers higher rates that may have more room to adjust lower if global monetary policies ease. Separately, if we reach a new trade agreement, emerging market debt may benefit as investors add some risk to their portfolios in the form of higher yielding emerging market debt.
  1. We maintain an equity allocation to defensive sectors which allows for equity exposure while dialing-back market sensitivity. Historically, these sectors have included healthcare, utilities, and consumer durables. Healthcare may face additional political pressure, but consumer durables should offer some downside protection, relative to other equity sectors, in a more volatile market.

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