This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.
If you aren't a GOT fan, then skip to the next paragraph. If you are, then you can appreciate how the current trade situation between China and the U.S. has all the drama of GOT. It's a bit like Daenerys Targaryen and Cersie Lannister trying to out-scheme one another, with the prize being the Iron Throne of the Seven Kingdoms. The Trump administration's chief negotiators, Treasury Secretary Steve Mnuchin and trade negotiator Robert Lighthizer, resemble Tyrion Lannister and Lord Varys. Despite playing for the same team, they seem to want different outcomes.
Over the last two years, the Trump administration has targeted China's trade deficit as one of its major foreign policy initiatives. And why not? China makes up more than two thirds of the U.S. trade deficit. (For those who've forgotten their Econ 101 class, a deficit detracts from economic growth). In 2018, the U.S. trade deficit for goods and services was $621 billion, up almost 13% over the prior year; $419.2 billion of that was a result of the imbalance in Chinese trade. The policy of levying tariffs on goods that are imported from China raises the cost of Chinese goods by the amount of the tariff. The thought goes that because those goods affected by tariffs are more expensive, U.S. consumers will buy less and thereby reduce the deficit. Alternatively, the administration seems to hope that some of those goods made in China will be made in the U.S., and that, too, would reduce the deficit.
This, however, belies the idea that we live in a world with a global supply chain and companies are most interested in making things closest to their customers. We already see some manufacturing returning to the U.S., and much of this is a result of the need to reduce time between steps in the supply chain.
In addition to wanting to reduce the deficit, the administration admirably wants to open the Chinese market further to U.S. companies and also reduce the amount of intellectual property taken from U.S. companies whose goods are copied in China without remuneration.
As trade negotiations appeared to be faltering last week, the administration announced an increase in tariffs on $200 billion in goods and services with the potential to add tariffs to another $360 billion. This was seen as a sign by investors that negotiations weren't likely to produce a favorable result anytime soon. As a result, stock prices have declined by over 5% from their recent all-time highs. (We must keep in mind that this decline in stock prices follows a rally of more than 16% since the beginning of 2019.)
Tariffs detract from economic growth. As you can see from the chart below, as tariffs are levied by the U.S. government, they will have a negative impact, albeit relatively benign.
For their part, the Chinese responded this week with an increase in tariffs on $60 billion in goods and services. You might wonder why such a relatively small response? Well, that's the inherent problem the Chinese have: Because their deficit with the U.S. is so large, the implication is that they don't import much from us, leaving them little room for similar retaliatory methods. However, both countries have other tools in the trade dispute tool box.
When tariffs were originally levied, they averaged 10%, meaning that they raised the cost of Chinese goods by 10%. Not surprisingly, China was able to reduce the value of their currency, the yuan, to the dollar by about the same amount. This currency value change offsets the tariff to some degree. One of the ways they did this was to reduce their interest rates by almost 2.5% at a time when the U.S. Federal Reserve was raising rates in 2018.
The problem, of course, is that when tariffs are raised to 25%, there is no way the Chinese can devalue their currency by that much. And, they aren't really in a position to reduce interest rates further. The gambit, then, is that a further increase in tariffs will be more difficult for them to offset and the result will be their willingness to come to the negotiating table to make a deal.
The Fed has changed course in 2019, indicating that it won't be raising interest rates until there is more evidence that it needs to. This would come in the form of faster economic growth (not likely given the moderating pace of growth both here in the U.S. and abroad) and higher inflation. On that score, tariffs raise prices, so there'll likely be higher inflation. Tariffs have the potential to raise inflation by another .2% to .4%, which pushes the current rate just beyond the Fed's target. However, the Fed will see that as transitory and not likely act upon it.
As of today, the Chinese haven't come forward – they've stepped back. Earlier this week, they indicated that they want three things: A deal that leaves them with dignity, an exclusion from agreeing to change their laws, and a commitment to not have to buy more goods than their country demands. Unfortunately, the first two won't come easily.
Stock prices rallied and bond prices sold off on news that a trade deal was nigh. With the recent news of the deal faltering, stocks have declined by over 5% and bond prices have rallied, with yields falling by almost .2%.
This volatility can be expected to continue, as a trade deal won't come easily. For our part, we will remain focused on what is fair value for stocks and reduce our exposure to those companies most negatively affected by the increased cost of goods. In addition, we note that the stocks that have performed best in this year's rally, technology in particular, are hit hardest when the market declines, as it did yesterday. Reducing exposure to momentum stocks at this juncture may allow for remaining neutral to our target stock exposure while becoming a bit more defensive.
We like the offsetting benefit of bond price rallies when stocks come under pressure and so remain just below neutral to our bond allocations.
It is too bad that Twitter didn't exist during GOT times. Tyrion said it best when he stated, “If you want to conquer the world, you must have dragons.” That would have made for a good tweet. The good news is that no one in the trade game has dragons!
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