Challenging Conventional Wisdom
Let’s start by stating the obvious. There is nothing conventional about President Trump or his administration. Whether it’s foreign policy or economic policy, the United States is taking a non-conventional approach when addressing today's issues. One of the biggest, if not the biggest, issue for candidate and now President Trump are unfair trade practices. He has often stated “trade wars are good and easy to win”. This week the President said, “tariffs are great”! We have disagreed with these statements and you would be hard pressed to find any economist that thinks a trade war or tariffs are good. Why then have the stock, bond, and currency markets been responding positively to the threat of a trade war and the implementation of tariffs? While we aren’t ready to buy into the White House’s mantra, let’s be open minded and try to understand what the markets might be seeing that we aren’t. Let’s also explicitly state that the real issue is China. Despite the spats with the EU and our NAFTA partners, this trade war is with China. Specifically, it is a response to Beijing’s strategic initiative “Made in China 2025”. Made in China 2025 was designed in 2015 as an "initiative to comprehensively upgrade Chinese industry". It is designed to move the country's manufacturing up the value chain.The goals include increasing the domestic content of core materials to 40% by 2020 and 70% by 2025. A huge focus of the plan is for the Chinese to develop their own high-tech so they won’t be reliant on foreign suppliers, especially the United States. China is developing a large part of their high tech industry by requiring any American company that wants access to Chinese consumers to establish a subsidiary in China that is majority owned by the Chinese. While certainly unfair to American companies, we believe the President thinks the bigger issue is this allows the Chinese full access to “steal” the American technology and more rapidly develop as a world super power. This will give the Chinese the ability to more strongly challenge the U.S. on global issues. As previously mentioned, economists almost universally believe if the trade war continues to escalate everyone will lose. Weakening global trade will depress global growth, while higher tariffs will boost inflation. This will lead the economy into a recession. A recession means lower earnings. Lower earnings mean lower stock prices. Higher inflation means higher bond yields and lower bond prices. It’s hard for us to dismiss this widely held belief. Our reasoning for remaining bullish has been that we don’t believe a full blown trade war will happen. Perhaps this is the markets reasoning too. However, there are a few economists who argue that a trade war won’t harm our economy. Rather, it will only harm the Chinese and will make our economy stronger in the long run. Okay, we are open minded enough to listen. Especially since markets are behaving like that is what they believe. YTD International stocks are down and US stocks are up, whether hedged or unhedged. In particular China and Emerging Markets are down sharply since the first tariffs were put in place. It appears, based on flow of funds data, that the world is betting on the U.S. and against China in this trade war. Money continues to flow into U.S. assets and out of Chinese assets.
This has forced the People’s Bank of China to cut reserve requirements sharply in recent weeks, contributing to a 7% plunge in the Chinese Yuan from its mid-April peak.
The argument being made by some stategists is that tariffs, or at least the fear of more tariffs, are creating a flight to safety in the U.S. Dollar. A stronger dollar relative to the yuan is offsetting most of the inflationary consequences for the United States. This is why our bond yields and inflation have remained low. Trump realizes this and knows that a weak yuan will cause the Chinese real pain, by increasing the yuan cost of buying dollar-priced commodities like copper, oil, and soybeans. China’s PPI inflation rate, which was 4.7% on a y/y basis in June, could go higher and put upward pressure on the CPI inflation rate, which was 1.9% last month. It's a reasonable theory, but lets hope trade issues are resolved before it's fully put to the test. We are concerned that China will prioritize their longer-term strategic aspirations over shorter-term economic growth. A realistic scenario over the next year is that the trade war and tariff threats neither expand or go away. In this scenario economic growth continues and markets remain volatile but ultimately higher. The performance of the S&P 500 sectors suggest that domestic investors are more concerned about rising interest rates resulting from a strong economy than about a trade war depressing the economy. Cyclical stocks are mostly outperforming interest-rate sensitive stocks. The strong GDP number released this morning has created a small sell off as investors are concerned the economy is running too hot, which will lead to monetary tightening. That's quite the opposite concern to a trade war leading us into a recession. Indeed these are strange times but we think the markets are, for the most part, getting it right. The economic and earnings data continue to improve and inflation remains well under control. We had record S&P 500 earnings reported this week. At GreenPort, while we are still concerned about the trade war ending the current bull market, our focus is also on our Federal Reserve beating China to the punch. The continuation of unnecessarily tightening monetary policy is starting to take effect. The yield curve has flattened materialy this year and Fed rate hikes will only flatten the curve more. A flat or inverted yield curve is usually followed by a recession. Next week we will expand on that concern. For now, we anticipate stocks will continue moving higher over the remainder of the year, with an extra helping of volatility. The GreenPort Team