Last week Robert Lighthizer, the current US Trade Representative, informed Donald Trump that the Chinese were backtracking on prior commitments to change laws regarding market access, forced technology transfers and IP theft. Trump did not take this well and publicly announced a new round of tariffs on imported Chinese goods, which dashed any hopes for a quick resolution to the trade tensions that have been gripping Wall Street for the last two years. This development roiled markets and, in response, there was a parade of Trump cabinet people trying to do damage control all week last week by speaking out to keep market hopes alive that a deal will get done. As a result, price volatility picked up significantly last week.
The reality is that the trade talks had been deteriorating prior to last week's announcement that the discussions were not making headway. This was due to a series of issues: The Chinese were upset that the US requested for Canada to detain and extradite an executive at Huawei, and the US was mad that China was not enforcing Iranian oil imports, because of increased Chinese military drills around Taiwan, and the belief that China had not done enough on North Korea following the failed summit in Hanoi.
From a bigger picture standpoint, it is probably wrong to assume that tensions like these will go away any time soon, and in the longer run it is probable that we will see increasing global tension, not just between the US and China, but between many nations. This should be factored into one’s investment positioning.
How will US - China trade issues resolve? Without being experts on trade negotiations, one possible scenario is that the Trump Administration will exert maximum pressure in the hopes of extracting more concessions. The Chinese, rather than making sweeping reforms to their entire legal system (which the administration wants it to do), may simply find it better to bide their time to see if Joe Biden, an avowed free trader, becomes the next president. It is hard to predict this, but our guess is that Trump will look for some sort of a deal prior to election season…even if it falls short.
The economic impact of tariffs and the policy responses can get complicated and they depend on the situation of the respective countries engaged in the tariffs. When unemployment is high (which it is decidedly not in the US at present) tariffs make more sense and are more politically popular. Therefore, support for protectionism tends to rise with unemployment, which is why they are popular with Trump’s base, but not so much in NY, California, and non-manufacturing areas. Obviously, there is no benefit to Wall Street from increased trade friction and it is dubious to assume (as the Trump Administration does) that there is a benefit to Main Street (taxpayers) because of increased government revenues from tariffs. Government revenues will never be sufficient to match spending.
The evidence suggests that US tariffs did not have much of an effect on Chinese import prices but did have a negative effect on US export prices. Grain and soybean prices fell noticeably in 2018 on days when trade tensions intensified and that was also the case last week where we saw corn trade down from $3.68/bushel to $3.46. That significantly hurts the US farming community.
It is possible that punitive tariffs could coax the Chinese to open their markets and improve intellectual property theft, corporate espionage, etc., but the Chinese won’t roll over easily. If Trump can get agreements from the Chinese on those fronts, he can then remove the tariffs and create a move favorable environment for American corporations and the global economy. This would be a bullish outcome.
But it is also important to keep in mind that China is not as dependent on exports as it used to be as Chinese exports to the US account for only 3.6% of GDP when they were 7.3% in 2006, so China’s incentives to strike a deal are lower today than they used to be. Moreover, China has plenty of tools to support its economy…it can initiate fiscal stimulus, expand credit, weaken its currency (the yuan), etc. US-based investors, in our opinion, are underestimating the Chinese’ ability to support spending throughout its economy and therefore are underestimating China's ability to be tough in negotiations. And they are also overestimating the potential negative impact to global growth because China can do a lot to stimulate its own economy while there are trade tensions.
That said, from a more tactical (shorter-term) perspective, there are heightened risks here with the tariffs and "trade war." It is silly for Trump to continue to tweet and jawbone high expectations to the market about how great trade talks are going with the Chinese, because a) it weakens his own negotiating position (the Chinese know that US markets have priced in high expectations on the trade front and therefore will be less willing to go along); and b) by causing a market rally through setting high expectations it also increases risk if those expectations disappoint. It is a mystery why Trump does this. It’s not a secret to anyone, including the Chinese, that Trump fixates on the stock market as a signpost of his own success or lack thereof, and if he disappoints by creating high expectations, he hurts US investors and himself politically.
From here, if Trump doesn’t offer some sort of a grace period and the tariffs are imposed, we could see increasing prices hit consumers. Increasing prices could force the Fed into a stance of being less dovish (dovish meaning leaning toward lowering interest rates or at least keeping them the same) and having to raise rates. The market is assuming and depending on continued stimulative (low) interest rates. If the Fed becomes less dovish, it will be bad for markets. But we also wouldn’t expect any selloff to be huge or long-lasting. If stock prices decline by 5% - 10%, it may make sense to add to some beat up equity positions, especially global equities (which are cheaper and would benefit more from stimulus in China). Chinese credit and fiscal stimulus are very high probability outcomes if the tariffs are imposed. Therefore, if global stocks sell-off significantly, it will be a long-term opportunity. Also, failure to reach a deal in the near term will not mean that talks are irrevocably broken down. It just means a short hiatus. Trump’s incentive is to show the American public that he is indeed a “master negotiator” by making a deal and to get reelected. Even if a deal with China falls short of today’s high expectations.
Despite the breakdown in talks and higher tariffs, there is still a good chance that the US and China will reach a temporary truce in the coming weeks. There is also a high likelihood that China will also ramp up credit and fiscal stimulus that will provide a cushion under risk assets (like global stocks, real estate and commodities). They may even provide too much stimulus in an overreaction (much like they did in 2009 and 2016). Either way, we will be paying attention to see what happens, and may do some repositioning depending upon how things go.
We would emphasize, that in an environment like this, where expectations for very good things are already priced in, it is supremely important to have investments in your portfolio that are priced at attractive levels (not overvalued or speculative levels). It is the most important thing you can do. Focusing on value will go a long way to reducing your risk of a permanent loss in today’s high-flyers that could result from US - China trade issues.
In today’s market this means avoiding technology stocks and being skeptical of the Wall Street and media hype that surrounds them. Recall that in 1999 Cisco was the largest company in the world. It was infallible. Its technology enabled the internet. The press and the market were infatuated with Cisco despite the fact that almost all of the economic profit of the business was transferred to insiders through stock option grants. Twenty years later, Cisco has only earned back two-thirds of the losses that ensued (post -Y2K) from its late-90s speculative top – a top made during a period of massive Fed support and low interest rates. It was the withdrawal of Fed liquidity that prompted market participants to price Cisco’s stock more rationally, and more broadly, was the beginning of a long and severe bear market in technology stocks.
Owning overvalued/speculative positions such as Facebook and Amazon that have been bid up by momentum and algorithm traders, means carrying unnecessary risk – those positions are more dependent on a dovish Fed and are far more at risk of a permanent loss of capital if the high expectations priced into them don’t materialize. It is important to know that returns are created as much by what you don’t own vs. what you do.
The advantage of Highgate’s investment process is that because our focus is on safety of principal and the value of what we own, we believe we get the double-benefit being able to earn high returns and carrying significantly less risk. When markets become adverse, we are not likely to suffer the painful declines that those who are trading in the most popular, and most expensive stocks will.
Thank you for reading our commentary and considering Highgate Securities Investments to help you meet your investment goals. We can be reached at 303-968-1230, or by email at firstname.lastname@example.org. You can also visit our website at www.highgatesi.com. We are happy to perform a no-obligation, objective portfolio evaluation for you.