The China Syndrome Revisited
At the depths of last year's market drop we wrote about the impact of a potential trade war with China. While we believed the threat of tariffs and a trade war were impacting markets, we attributed most of the sell-off to an overly aggressive Federal Reserve policy. Our reasoning for giving less importance to the trade war than others was two-fold. We believe this trade war, like the trade wars with Mexico, Canada, and Europe, will not become an extended full blown trade war. Our primary reasoning is that when both sides stand to lose, rational minds will find a compromise. Our secondary reasoning is that a trade war with China would not impact our domestic economy and corporate profits anywhere near as much as many economists predict. Many doom and gloom economists are looking at the higher production costs in the United States vs. China, and predicting a comparable decrease in U.S. earnings. We believe this is faulty analysis. If a trade war persists, most U.S. companies will not shift their production back to the United States. They will likely go to Vietnam, Thailand, Mexico, or some other low cost producer. U.S. companies can also pass some of their higher production costs along to the consumer. While this is not optimal for the consumer, and certainly disruptive for corporations, we don't believe this would be catastrophic for the U.S. economy. The U.S. economy has been consistently running at an inflation rate below the Fed's target, a minimal increase in inflation is not overly concerning. Additionally, the U.S. consumer continues to drive our domestic economy. A trade war impacts a net export economy (China) far more than a net import economy (United States). We also developed our mosaic theory on why the trade disputes with every country but China had been resolved, or at least greatly improved upon, while the trade war with China continues to fester. The popular answer among economists and pollical pundits is that China can’t be bullied by the U.S. like those other countries. China has a “President for Life” in President Xi. He doesn’t need to worry about re-election or the short term economic impacts of a trade war. China is an economic superpower that can withstand U.S. tariffs. Generally speaking, the consensus is that China will not give in to our demands like those other countries. To the contrary, they will retaliate with their own tariffs. This is what appears to be unfolding this morning. Our mosaic is that while trade is at the center of this dispute, this is not a trade war. Instead it is about who will be the global superpower of the future. It’s plausible that the real strategy for the Trump administration is not to reach a trade deal. While we don't think that is the case, we do think the U.S. has the incentive to make the terms of any new deal so strict that this trade war may never be fully resolved. Rather it will be a system of unpredictable on again - off again tariffs that will discourage U.S. companies from investing in Chinese production. The entire Western world, not just the United States, is extremely concerned about China. China has been spending enormous amounts of money to build out their military power. The extremely contentious man-made islands in the South China Sea have now been militarized despite President Xi’s 2015 promise, “no intention to militarize these islands”. Military bases on these islands now have anti-ship and anti-aircraft missiles. It takes money to do this. The Chinese economy must continue to be strong in order for China to pay for their ambitious military agenda. So, while it’s fair for the President to point to unfair trade practices and the impact on U.S. workers since China joined the World Trade organization (WTO) in 2001, Trump’s real agenda may well be to target the Chinese economy. China's one-child policy is already an incredible burden on the Chinese Economy. Combining this formidable headwind with tariffs on an export reliant economy is starting to inflict real pain.
It reminds us of President Reagan's approach to the Soviets. Ultimately the Cold War ended when the Soviet Union went bankrupt. Perhaps this is more of a cold war than a trade war with China?
Our best guess is that we are in for a lot more volatility over the next several months, with some significant market pullbacks along the way. We acknowledge trying to time these short-term moves is not our forte. Our strength lies in understanding longer term trends and focusing on the fundamentals. As of a few weeks ago we were at all-time highs. We still believe markets will move higher over the remainder of the year and ultimately finish the year at or near record territory. We simply can't predict how crooked and unnerving that path may be. Have a Great Week, The GreenPort Team