o our surprise, both President Trump and President Xi appear to be positioning for an extended trade war. China is compiling a list of “unreliable entities” that “damage the legitimate rights and interests of Chinese enterprises.”
By keeping the qualifications for this list broad and intentionally vague, China has created a vehicle for retaliating against American companies operating in China. On June 2nd, the Chinese government released a statement suggesting they were open to further negotiations but indicating that potential concessions would be coming primarily from the US.
Meanwhile, President Trump has opened a new front in the trade war by threatening Mexico with tariffs over illegal immigration. These proposed tariffs would violate Trump’s signature trade accomplishment, the renegotiated trade agreement between the US, Canada and Mexico. By potentially violating his own trade agreement, President Trump has created significant uncertainty as to whether his administration will ever consider a trade dispute permanently resolved.
This uncertainty casts a cloud over all current trade negotiations. Chinese negotiators might be reluctant to reach a compromise solution if they believe the Trump administration could subsequently violate the terms of any agreement reached, with a resulting loss of face for China and President Xi.
The escalating trade dispute pushed the S&P 500 down through several technical support levels. After each technical breakdown, equity investors have defended the next support in the hope that Presidents Trump and Xi will hammer out a compromise at the upcoming G-20 meeting.
By contrast, bond investors appear skeptical of a last-minute rescue for the global economy and that the damage already done to global economic confidence can be easily repaired.
Over the past month, bond rates have fallen from 2.50% to 2.13% on 10-year treasuries. Unfortunately, the skeptics in the bond market have thus far been far more prescient about the course of trade negotiations than we and our fellow equity market optimists have been. If a breakthrough occurs at the G-20 meeting, then the strategies outlined in our May publication still apply. However, the grim developments of recent weeks require that we consider the economic and market consequences of a full-blown trade war.
Assuming that the current trade dispute with China remains unresolved, we believe that:
Current economic and financial conditions are very different from those that helped turn the Smoot Hawley tariff into a global depression. The US was essentially the China of the 1920s, running large trade surpluses and providing the capital to rebuild Europe after the devastation of World War I (a country’s trade surplus equals the capital that it invests abroad).
By initiating a trade war, the US inflicted immediate damage on its own trade dependent economy and simultaneously cut the rest of the world off from badly needed US capital investment. These economic body blows were exacerbated by heavy debt burdens and an inflexible gold based monetary system, resulting in wide spread bank failures and a global depression.
Like the US in the 1920s, China’s dependence upon exports to the US means that its economy will likely bear the brunt of any trade war. Economies that are heavily dependent upon Chinese demand (Australia, South Korea, Japan) could slow along with China.
However, unlike the 1920s and 1930s, global currencies are no longer tied to gold. The 8% decline in the Chinese yuan over the past year has already softened the impact of the Trump administration’s tariffs, and the Chinese government has the option to further weaken their currency at anytime. Adjusting to tariffs through a depreciating currency essentially cuts the pay of Chinese workers but reduces the tariff’s impact on global growth.
No matter how ugly the trade dispute becomes, the US does not need to worry about being cut off from capital the way US trading partners were in the 1920s and 1930s. Currently, the US trade deficit and associated capital inflows are simply transitioning to other high savings rate Asian economies (see chart below).
If President Trump extends his trade war to these other Asian economies, then a Federal Reserve freed from the gold standard can simply resume printing money and buying government bonds. This policy, known as quantitative easing or QE, allows the Fed to print the money required for the country’s capital needs.
The 2008/2009 recession was exacerbated by heavy debt burdens for US consumers and US companies. By contrast, although corporate debt is back to record levels as a percentage of the economy, US consumers are currently in a much stronger financial position than was the case in 2008/2009 (see chart below). Healthy consumer balance sheets should prevent the collapse in consumer spending that made the 2008/2009 recession so painful.
Much of the increased corporate borrowing has been from investment grade corporations borrowing money to buy back their stock. These stock buybacks accelerated growth in earnings per share and helped drive equity markets higher.
Investment grade borrowers have the size and financial strength to prevent the level of defaults seen in the last recession, but stock buybacks and the associated earnings growth are likely to disappear if the economy slows.
Additional pressure on earnings could come from companies with substantial Chinese operations being added to China’s list of unreliable entities, and from companies dependent upon Chinese suppliers absorbing the costs of relocating their supply chains.
However, many of the most important companies to the US economy and US equity markets were shut out of China long ago (Amazon, Google, Facebook, etc.). The very unfairness of China’s trade practices provides some protection from Chinese retaliation for several sectors of the US economy.
President Trump has entered into trade disputes with every major US trading partner. His proposed violation of the new trade agreement with Canada and Mexico reopens that dispute and means that none of these trade conflicts have been resolved.
If a trade war erupts with China, then resolution of these myriad other trade disputes becomes absolutely critical to continued economic growth and President Trump’s reelection hopes, in our opinion. Flexible currencies and money printing by central banks cannot fully offset the economic damage that a global trade war would inflict.
We still believe that the political and economic costs of a trade war will force President Trump and President Xi to reach a compromise agreement. However, we recognize that the odds of a trade war have increased substantially in recent weeks. If a trade war is confined to China, then the US economy could escape with a mild recession. Corporate earnings would likely suffer far more than the economy.
Such an earnings recession could prompt a normal market correction of 10% to 15% and would likely retest the lows of December 2018. A relatively rapid recovery in US economic growth should prevent a secular bear market. The bond market in recent weeks has priced in about 100 basis points in Fed easing, from a 2.5% Fed Funds target to about 1.5%, and we believe that is about as much Fed easing as is likely to occur provided the trade war is limited to China.
If the Trump administration allows trade disputes to continue spiraling out of control and impact virtually every major US trading partner (which we consider unlikely since it would be political suicide), then the global economy could endure another deep recession and stocks suffer an extended bear market. A recessionary correction of more than 25% should be expected along with a return to post financial crises lows for interest rates.