Why did the early August market sell-off occur?
Tensions were ratcheted up by President Trump calling for another 10% of tariffs on an additional $300 billion of Chinese goods. In response to this threat, China halted purchases of US agriculture goods – namely soybeans. As a result, investors seemed to fret over the risk that the global trade spat between the US and China was moving to a new level – one that could open up a new front that includes a currency war. A currency war occurs when two countries begin to competitively devalue their currencies in the effort to gain a trade advantage, with a cheaper currency translating into cheaper goods.
The early August moves by the US and China appeared to be the catalyst for an equity swoon which saw a massive flight to quality, with investors moving money to positions where they believe there is less risk, such as government bonds. This trend was highlighted by a sudden and sizeable drop in government bond yields across the world.
Was China’s currency decline a major factor?
While many point to the Chinese currency depreciation as the catalyst for the market sell-off, there were plenty of other cross-currents in the market making investors nervous. These include the October 2019 Brexit deadline, economic challenges faced by Italy, unrest in Hong Kong, slowing global growth, and softer guidance from companies reporting earnings. The proverbial “Wall of Worry” seems to be growing larger, and the recent market volatility is more a result of a number of factors all coming to a head rather than just one single worry.
Why is the US-China trade war affecting markets more now than in previous months?
Markets don’t like uncertainty. While the trade tensions have lingered for over a year already, investors had seemingly become relatively comfortable with the recent backdrop of tariffs and political rhetoric. The latest bout of CNY (Chinese yuan) weakness altered that backdrop, introducing a new concern that has largely been talked about but not yet witnessed – financial asset weaponization. This term refers to the use of capital markets access by governments as a tool of foreign policy.
While many have cited worries over a weaker CNY – or even an outright devaluation – the Chinese currency has remained fairly well behaved thus far, actually demonstrating strength more recently relative to some of its Asian counterparts. The recent weakness has now introduced a new level of uncertainty, one that many pundits have been eyeing as a potential red herring for an escalation of retaliation. Combine this with what now appears to be a global manufacturing recession in Europe that continues to cause malaise and that results in an increase in overall worry in an ever more fragile economic environment.
Who pays the tariffs on Chinese imports to the US?
Economics 101 teaches us that the importing country – the US – is paying the tariffs imposed on Chinese goods. This is why tariffs are often thought of as a tax on the consumer, because the costs associated with paying the tariffs are assumed to be passed on to the domestic consumer in the form of higher prices. However, some of the data here is not entirely clear in terms of supporting this view, given recent observations. There is evidence pointing to somewhat of a shared burden – some of the costs associated with the tariffs are being paid on the US side while some are being absorbed from the Chinese side as well. Supply chain redistribution and diversification has been one of the by-products of the trade war, with some Chinese companies willing to absorb portions of the tariffs in order to continue to supply US producers with their goods. Because some Chinese firms are at risk of having limited options in terms of buyers of their products, they are agreeing to absorb some of the costs associated with the tariffs rather than lose business or shut down.
What sectors of the US economy are most vulnerable to US tariffs on Chinese imports?
It’s difficult to point to a single sector that is most vulnerable to US tariffs on China. Rather, a company-by-company analysis might provide some greater insight. Firms that have flexible supply chains will obviously fare better in this environment, shifting imports to regions that have not been impacted by tariffs. For example, one tech company has indicated that it has shifted production out of China to other regions of the world seamlessly, leaving the impact from the tariffs almost nonexistent. Additionally, companies operating with healthy margins would also stand to weather the tariffs much more effectively, as they have the ability to better absorb some of the costs associated with the tariffs.
These characteristics are often common to larger and more established companies, whereas the smaller and more nascent firms have yet to build out diversified supply chains. Many small-cap companies lack the capital to diversify their supply chains and therefore have no alternatives – the Chinese suppliers that are currently being utilized are the only options they have to supply certain inputs. This dynamic is what is responsible for the relative performance in cap size as we see US large-cap stocks outperforming US small-caps this year.
How does the Trump administration’s policy of increased tariffs relate to the Fed’s recent interest rate cut?
Trade tension has certainly complicated the Fed’s job. The uncertainty is casting a dark shadow over business sentiment, and the knock-on effect is a slowing manufacturing backdrop. Complicating matters is the absolute level of interest rates – at such low levels, the marginal benefit from lower funding costs becomes smaller and smaller.
The current slowing of global growth is likely not a function of depressed demand. Rather, it is likely one of confidence. Capital is relatively cheap already, and banks are certainly demonstrating the willingness to lend. The issue, I think, is about the willingness of companies to borrow, and this is a function of expected returns and confidence. So while the lowering of rates by the Fed might have less of an impact today than in previous easing cycles, the signaling effect is just as important: that the Fed is willing to do something to help support growth and not just sit idly by.
The Fed signaling its willingness to ease to support US growth could very well embolden President Trump to continue to pressure China through an aggressive tariff policy. A strong stock market and an expanding economy certainly are key political ingredients for a presidential second term, and an easier Fed will certainly help with this. A tougher stance on China is still resonating with Trump’s voter base for now. It’s not hard to see a vicious cycle at work: a more accommodative Fed helps to support the US growth backdrop and risk sentiment (US equity market), which then emboldens President Trump to continue to pressure China through an aggressive tariff campaign. The battle will likely continue to rage on – trade tensions versus easier monetary policy. Whichever one wins out will certainly have very different outcomes for financial markets.
Is a comprehensive US-China trade deal possible? What might a realistic deal (or deals) look like?
This is the million-dollar question. Is a deal feasible? Yes. But a deal will certainly require concessions from both sides. All indications point to both sides being very far apart on this. Both sides have a vested interest in negotiating a deal, but both sides also have reasons to continue to draw this out. China certainly has the means to wait until the 2020 elections have been decided in hopes of dealing with a more conciliatory president. And Trump certainly has no reason to back down, with a stock market close to all-time highs, rock solid voter base support and a US jobs market that continues to remain strong. It certainly feels that until something breaks, we are set to see more of the same as we head into 2020.
Should investors be ready for more market volatility?
Investors should continue to expect more of the same. Until we see a slowdown in the US economy, a significant correction in the equity market and/or a deterioration in Trump’s approval rating from his constituents, it’s difficult to see the US administration backing down from its current stance regarding China. Markets had become comfortable with economic prospects until this latest tariff increase forced a reset of investor expectations. The latest dovish tilt from the Fed has certainly helped offset the recent escalation, and the market seems to now be in the process of digesting a new base-case scenario. It is this re-pricing of expectations that creates market volatility.
Again, any near-term resolution does not appear to be in the offing. Any incremental escalation in trade rhetoric will most certainly ignite increased market volatility as investors continue to worry that late cycle dynamics will finally morph into a recession. While we still are not in the recession camp for 2020, we certainly recognize a key risk for the markets going forward: a policy mistake from either the Fed or the Trump administration. Regardless, volatility is back and likely to persist as the 2020 presidential election season ramps up. Time to get used to it – we’ve been spoiled over the past few years.
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