Trade War Sequel: 4 Things We Like & Don’t Like

Aug 07, 2019 | Irene So & Richard So


Reviewing the latest escalation in the trade war

While Canadian investors were enjoying their August civic holiday, markets experienced the largest drop of the year due to heightened trade tensions between the US and China. On August 1, President Trump announced that America was planning to add a 10% tariff on $300 billion of Chinese imports. With these added tariffs, the US is essentially taxing all imports from China, 60% of which are consumer goods. In retaliation, the Chinese suspended purchases of US agricultural imports, allowed their currency to weaken and may be tightening their overview of foreign firms operating in China. Needless to say, the economic relationship between the two nations has become colder. If President Trump claims President Xi is his “good friend”, we aren’t quite sure if we would want to be his friend!

In the midst of heightened volatility and uncertainty, we seek to transparently share how our team interprets the current conflict and how it influences our investment decisions.

What we don’t like

1. No follow-through (yet): At the time of this writing (Aug 6th), market indexes have indicated a positive open. Although it may seem odd for an investor to view rising markets as a negative, we would much rather see continued downside pressure and some follow through to yesterday’s losses. Allowing markets to flush out the negativity enables the market to adequately price in any revised expectations for slower earnings growth. It would also give time for those investors, so called the “weak hands”, to succumb to their lack of conviction and exit their holdings indiscriminate of their fundamentals. Without a capitulation in selling, it becomes more difficult for the market to put in a “bottom” and perhaps signals that markets may be tracking time in a range bound manner.

2. Compounding International Tensions: Timing of this trade war escalation comes on the back drop of other international concerns that compound the uncertainty of the global outlook. To highlight a few conflicts, we read headlines regarding the protests in Hong Kong, further unrest in Kashmir, renewed North Korean missile tests, and the heightened likelihood of a Turkish invasion of northeast Syria. Meanwhile, Britain and developed Europe’s’ political and financial woes continue.

3. Dependency on Further Rate Cuts: The market is currently pricing in a greater probability of further interest rate cuts from the Fed. Investors are increasingly expecting a 25-50bps rate cut in September and another cut in December. With these rising expectations comes heightened risks of the Fed not delivering on those rate cuts. The latest Fed meeting provided little clarity on the future intentions of the Fed Chair, Jerome Powell. His press conference implied that this may have been a “one-and-done” rate cut, however, he did leave the door open to further cuts. Ultimately, the Fed may not have the justification to cut rates further until they actually see the economic data revealing the negative effects transpiring from the trade war. This unfortunately may take some time, which leads to a prolonged period of uncertainty and volatility. Finally, should the Fed cut rates, other countries may also cut their rates thereby leading to a global easing cycle which may exacerbate fears that global growth is waning.

4. Currency War: Adding fuel to the fire, the US Treasury Department has designated China as a currency manipulator. From this development, the trade war becomes a multi-faceted conflict. This designation will prompt the US to engage in a direct negotiation in currency issues with China or pursue its case with the International Monetary Fund (IMF). This creates more potential negative headlines and creates another challenge to solve.

What we like

1. Strong Fundamentals: It should not be surprising to our readers that our investment decisions ultimately hinge on the fundamentals which still signal the continuation of an expansion. Fears of a recession have been subdued after Q1 GDP growth printed 3.1% and Q2 beat expectations at 2.1%. Corporate earnings also remain positive with the latest quarter’s earnings exceeding market expectations. As of the time of this writing, 413 out of 500 companies have reported Q2 earnings with 74% beating, 8% meeting and 18% missing expectations. Finally, market valuations remain fairly priced, as the S&P500 Forward P/E multiple sits at 15.6X. With interest rates at these low levels (and perhaps heading lower), some investors believe the market multiple should be at a premium to the long term average multiple of 16X. Ultimately, earnings have successfully kept pace with the growth in stock prices.

2. Little Impact to the Economy: The Impact of this latest 10% tariff on $300B of Chinese goods places more pressure on China’s companies and economy than on the US. While American consumers could face a modest rise in prices, the total impact would be the equivalent to 0.1% of the $21 Trillion US economy. Moreover, the previous round of tariffs do not seem to have caused irreparable damage to the economy, nor have they been able to push inflation meaningfully higher. Finally, China’s retaliation of suspending agricultural buying appears to have more political implications than economic. Trump’s hopes for re-election relies on support from the “Farm states”, however, US agricultural exports to China represent less than a fraction of 1% of GDP. Ultimately, the US is a service based economy and does not depend on exports.

3. The timing is right: For many clients we have already communicated our expectation that a trade deal may not actually come to fruition as Trump sees less pressure to sign a deal. We see growing bi-partisan support for confronting China on their practices related to trade and forced technology transfer. This has been reflected in the little air-time that the televised Democratic Party Presidential Debates have given to discussing the trade war. With this in mind, it makes sense to us that Trump would want to go on the offensive. The timing could not be better as the consumer is strong, the economy is healthy, unemployment is low, corporate earnings are exceeding expectations and elections are still 15months away. A clear pattern has formed throughout this trade war. When the market prices in too much negativity, Trump tends to step in to boost investor confidence with hopes of trade progress or new policies. We do not see why this time would be different.

4. Dividends Look Great: Treasuries around the world are very low. Internationally, there are currently $15 Trillion of negative yielding bonds. This equates to 44% of non-US bonds in the developed world paying negative interest rates. At the time of this writing, the 10 Year German bund is yielding -0.51%. With the 10 year US Treasury paying 1.7% and the 30 year paying 2.23%. As a result, dividend yields from stocks look extremely attractive. For those pension funds, institutions and retirees who need income, dividend paying equities are becoming the only steady choice and should provide support to the market and future growth in equity prices.

What to do from here

We remain vigilant in watching further developments. We brace ourselves for the possibility that Trump becomes emboldened by the lack of meaningful retaliation from China, which could lead to increasing tariffs to 25%. On the other hand, a sign of good faith for further cooperation would be to see small concessions from China like curbing fentanyl exports or following through on the agricultural purchases agreed upon in the G20 Summit in Argentina.

We believe investors cannot get too negative yet. The latest trade barriers do not warrant making abrupt changes to equity portfolios. As we have seen in the past, political conflicts typically provide buying opportunities as they have more short term rather than long term impact on the markets.

At this time, the market is not at oversold levels, so it does not justify aggressively buying this pullback. Rather than only looking at those stocks that have been beaten down the most, we also look at stocks that have held up nicely during this most recent consolidation. If market tensions continue to deteriorate, those names that have thus far outperformed should continue to outperform. They may even become the new leadership stocks under a scenario of stalled negotiations. Many stocks that have little revenue and business tied to China have been falling in sympathy with the broader market selloff and these are the names that should be added to one’s radar.