A Clash of Civilizations
Rarely in markets can we be completely certain of what is causing them to move. The industry joke is, “more sellers than buyers,” when equity markets head lower. We find ourselves in one of those rare moments where there is no question around what is causing the current selloff.
First, a timeline:
On July 31st, the Federal Reserve announced a 0.25% cut to its benchmark interest rate, the first in over a decade. In our view, there was no fundamental economic reason for cutting rates. From what we can tell, the rate cut was almost exclusively a reaction to market participants demanding low rates (i.e. free money). Based on the market’s reaction, more was expected.
The very next day, after being disappointed in a singular rate cut, President Trump announced a tariff of 10% on $300B of products coming from China starting September 1st. This is in addition to the 25% tariffs already imposed on $200B of goods. A series of dizzying counter-punches ensued. China, almost predictably, allowed or forced their currency lower against the dollar to the lowest level in over a decade (Chart 1). China also stopped all purchases of US agriculture products. Next, the US Treasury Department labeled China a currency manipulator for the first time in more than twenty years.
Chart 1 – CNY/USD Exchange Rate – Bloomberg 8/7/2019
Equity markets and bond yields around the globe dropped precipitously in response. The S&P 500 fell nearly 7% from all-time highs, before bouncing over the last two trading session. The 10-year treasury blew through 2.00%, hitting a low of 1.60%.
So, what is going on? Over the past forty years, the US has lost seven million manufacturing jobs, and over the same time the country added 100 million people. From 1999 to 2013, China transitioned a half a billion people from poverty into the middle class. A tremendous feat by any measure, and much of it (possibly most of it) came from China acting as the manufacturing hub for the world. It is indisputable that their strategy benefited the citizens of China.
China and the developed world face two different problems with a similar solution: there are still hundreds of millions of people China would like to lift out of poverty, and developed world population growth is slowing. In fact, population is declining in some parts of the developed world. While a crude example, think about modern economies like functioning Ponzi schemes – as long as you are adding to them, they work. GDP has four components – Consumption, Investment, Exports and Government Spending. If your population is declining, or aging, less consumption is required. To the extent consumption influences business investment the two can decline together as lower consumption leads to less need for business investment. That leaves only exports and government spending to plug the gap left by declining consumption and business spending. Governments around the world are spending more than they are taking in just to keep their economies running. The last component is exports. Every country desperately wants to increase their exports and decrease their imports, and therein lies the problem: both China and the developed world need to increase net exports to continue to address the problems mentioned above.
If you combine China’s desire to maintain its role as the global manufacturer and an American President whose signature campaign promise was to be the first president in modern history to take on China over a number of issues, the end result is a collision course. When speaking with clients we have been voicing our concern over this battle for the past year. China views this as a waiting game. The next catalyst is the election in 2020. If Trump losses, the pressure will be off China and the status quo will return. If Trump wins, they might have to strike some sort of deal. President Trump needs to avoid a recession and strike a deal that is both measurable and enforceable, so he has a major win to run on. We view this as a high stakes game of chicken where Trump needs to both avoid a recession and sign a meaningful, measurable and enforceable deal. China needs to hold its economy together until Trump losses the 2020 election or, comes to the table to sign a largely symbolic deal with little to no impact on trade with the communist country. To the extent China can hasten a recession in the US, they will. We do not think it is a coincidence that President Trump increased tariff pressure on China and the North Koreans, a staunch ally of China, started firing off rockets again.
If we assume the worst-case scenario is a 25% tariff on the entirety of Chinese exports to the US ($500B), and that the entire cost is passed directly onto the consumer, that would result in a $125B hit to consumers or $1000 per household. Although $125B is less than 1% of US GDP, the approximate impact to US corporate profits is a decline of 6%. Thus, without question, the immediate impact of tariffs is negative for growth, corporate profits and/or consumer bottom lines. That having been said, we never worry about a 1% rise in inflation throwing the economy into a recession, which is effectively what this is. It’s an increase in the cost of doing business or increase to consumer prices, without the corresponding benefit of the inflation coming as a result of increased demand in the economy.
We think there’s a greater than 50% chance of a recession next year, but the China trade tariffs will not be the direct cause of that recession, should it come to pass. The increased uncertainty should push down multiples, increase volatility and depress rates. All of these factors have already begun. We think this continues until a meaningful deal is struck or a recession is imminent.
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