By Jennifer Hutchins, CFA
Portfolio Manager, Investment Management Research Group
With a very strong start at the beginning of 2019, the market has hit a few bumps recently, with most of the additional volatility being attributed to China/US trade relations. Nevertheless, all major indices remain positive both domestically and internationally through the end of April.
Volatility is a normal part of a standard business cycle. In fact, since the low point of the Great Recession was struck in March 2009, the S&P 500 Index has seen approximately 16 drawdowns of five percent or greater.
S&P 500 Growth between 3/9/2009 and 4/30/2019
(contractions defined as 5% or more in drawdown from a peak)
Source: Morningstar Direct
However, the S&P 500 doesn’t seem to be egregiously priced at current levels. Forward price-to-earnings (P/E) ratios, for example, are approximately 16.6 times (16.6X) which is near the 60-year average of 16.94 times for the index (May 1, 1959 – Apr. 30, 2019).By this metric, the S&P 500 appears to be close to fair value.
On May 10, it was widely reported that $200 billion of Chinese imports into the U.S. will now be taxed at a rate of 25 percent, an increase of 15 percent from previous levels. While the new tax rate only applies to a portion of total U.S. imports from China, many see this as an indicator that the probability of additional tariffs (on the remaining $300 billion of additional goods) could come later this year. President Trump has warned that the necessary documents are currently being crafted should an agreement not be reached with President Xi of China. As expected, China slapped retaliatory tariffs on $60 billion of U.S. goods on May 13 at the same rate of 25 percent. This tax on U.S. exports to China will take effect on June 1, 2019.
While acknowledging the dangers of trade wars and their potential negative effect on the pocketbooks of consumers, consider a few potential reasons that President Trump may be digging his heels in on this issue.
First, remember that China is a communist nation, and unfortunately free market and free trade philosophies are challenging to apply. The private sector in China, which contributes a greater percentage of GDP than the state sector, is still very receptive to the state – and China isn’t classed as a market economy by the World Trade Organization, in part because of how much the state intervenes.[1]
Another point to consider is that China has historically had higher tariffs on imported goods than the U.S has charged on China’s imported goods. Furthermore, China’s tariffs on our goods have been significantly higher than the majority of America’s other trading partners. Working to decrease or eliminate these disproportionate tariffs are favorable. Recall that President Trump proposed to remove all tariffs between G7 nations at the summit last year, but received no support from fellow global leaders. It would seem that President Trump is attempting to apply Adam Smith’s free trade theory, where there are no barriers (aka tariffs) that would dissuade efficient use of a country’s resources, setting the world stage for better pricing and freer competition.
Then, there is China’s problematic stealing of highly valuable research and development intellectual property from several countries not just the U.S. China’s cyber pickpockets have stolen numerous state and corporate assets which the government, companies and individuals invested billions of dollars developing for the good of the American people and our economy. This issue needs to be directly addressed and China should be held accountable for these actions.
Nonetheless, a tariff, which is akin to a tax on consumers, isn’t going to be a popular course of action and has the potential to lead to less spending by consumers and slower growth in certain sectors.
However, it is critical to view the impact of these tariffs in full context of America’s overall economy. When you consider that the U.S. consumers spend $13-14 Trillion[2], it’s unlikely that $100 billion in tariffs will strain the U.S. economy to the point of recession. [3] This context is not intended to trivialize the individual impact a trade war could have to anyone’s livelihood, such as those in the agriculture sector, but to illustrate the long-term benefit of rectifying U.S.-China trade relations could be significant. Especially in areas like U.S. technology companies, which will likely be the main drivers of future economic growth and are currently exposed to the piracy of their best and brightest ideas from Chinese cyber criminals.
Finally, it would seem China’s economy could be hurt far worse by these tariffs long term than the U.S. economy. Giving some additional context, the U.S. exported $180 billion in goods and services to China in 2018, which is approximately 0.9% of U.S. GDP. On the other hand, China exported $559 billion to the U.S., the equivalent of 4.6% of China’s GDP.[4] Based on these figures, it would seem China should be more eager than the U.S. to come to acceptable terms of new agreement. If the trade war were to persist at length, the U.S. could ultimately shift some supply chains to other nations such as Singapore, Vietnam, or Mexico. The beauty of capitalism is that when one door is shut, innovation and technology construct a new one, typically better.
While the U.S. is not the only developed economy from which China has poached, the U.S. appears to be the only nation fighting back, albeit in a controversial way. Whether China will admit it or not, they need “the West,” the U.S. in particular, to support growth in the country’s economy. Trading with the likes of North Korea, Russia and Venezuela simply will not fare well for Xi’s long-term growth trajectory. Thus, it is highly likely that a trade deal will ultimately occur.
Yet, until the minutia of this trade agreement can be resolved, it will be challenging for certain U.S. businesses who import parts and materials from China, as well as for those firms who export goods to China. Technology and hardware companies will feel the burden most heavily as well as certain firms in the industrial sector.
Industries and sectors that are anticipated to be less impacted by the trade war include more service-oriented sectors, as well as those industries that drive more revenue domestically, such as banks and insurance companies. Also, companies that have very strong pricing power, such as high-end sportswear, jewelry or luxury cars, may be slightly more insulated from the effects of increased tariffs. There is likewise some potential insulation in the energy sector as the U.S. continues down the path of energy and oil independence.
The bond market has not escaped impact from the recent market volatility. As uncertainty in the market place spikes, a flight to safety typically follows, putting downward pressure on the yield of the 10-year U.S. Treasury note and brings the gap between the 2-year and 10-year Treasury yields closer. The current spread is approximately 0.19% (as of 5/17). A slight inversion of approximately three basis points (0.03%) continues to persist between the 2-year and 5-year Treasury yields, with this inversion first occurring mid-December 2018. As outlined in a previous article from the Investment Management Research Group at 1st Global, The Implications of an Inverted Yield Curve, this inversion may not infer an impending recession. The market continues to monitor messaging from the Federal Reserve Chairman Jerome Powell and watch the Fed’s next move. Chairman Powell appears to be proceeding cautiously as he works through his first year at the helm of the Federal Reserve Committee (FOMC).
While inflation rose to 2% in April (up from 1.9% in March), it appears to be in check currently, at what some consider the “neutral” level. The April unemployment rate in the U.S. hit a 50-year milestone with a record low of 3.6%, while year over year wage growth rose to 3.2% (up from 2.8% in April 2018). Additionally, the first quarter of 2019 saw a 3.6% increase in productivity, above the 2.4% growth seen in the same quarter of 2018. This growth in productivity is important to note, as many economists believe that a congruent rise in wages and productivity help stave off inflation pressure. Finally, estimates of U.S. GDP for the first quarter of 2019 show that the economy grew at annualized 3.2%, surpassing GDP growth in the fourth quarter of 2018 and GDP growth for the prior year. These metrics do not paint an economy in distress but rather portray a healthy economy.
As investors ponder what the future has in store, it’s important to try to remain distant from the current “noise” or media hype and focus on investing for the long-term. Since we are aware that business cycles ebb and flow, it is imperative to establish a long-term financial plan to refer to each time the tide gets rough. In the short-term, volatility is likely to continue, and may even increase, as the markets wait for an agreement between U.S. and China. While trade wars are not consumer-friendly, making an effort to better position the U.S. from a trade perspective while attempting to thwart a communist nation from stealing American’s technology is something to be applauded. Economically, the U.S. appears to be healthy, as it continues on the slow growth track; an increase in tariffs is unlikely to be derail this trajectory in the short term. With China having seemly much more to lose than the U.S., maybe a little hardball in the short-term will lead to fairer and freer trade and competition in the future.
About Jennifer
Jennifer Hutchins is a portfolio manager for the Investment Management Research Group at 1st Global, where she supports the ongoing adoption and retention of assets of the IMS platform through asset allocation, investment manager due diligence and risk management. Jennifer received her Bachelor of Arts degree in political science and economics from Christendom College, and her love of mathematics and economic studies eventually led her to pursue a career in the financial services industry.
Bibliography
“Finding Opportunity Amid Trade Turmoil.” Manning and Napier, Market Commentary, May 8, 2019
Phillips, Alec and Taylor, Blake. “USA: Tariff Increase Takes Effect as Soft Deadline Passes.” Goldman Sachs, Economic Research, May 10, 2019
Wesbury, Brian. “Trade War Hysterics.” First Trust. Monday Morning Outlook, May 13, 2019.
Wesbury, Brian. “The Big Picture and the Fed.” First Trust. Monday Morning Outlook, May 6, 2019.
Wells Fargo Investment Institute Conference Call. “Special Market Volatility Update.” May 13, 2019.
Wesbury, Brian. “Good-bye Recession Fears.” First Trust. Monday Morning Outlook, May 6, 2019.
Virk, Kameron.
“Is China actually a communist country?” The Irish Independent, October 19,
2017.
[1] Kameron Virk, “Is China actually a communist country?” The Irish Independent, October 19, 2017
[2] Trading Economics, U.S. Bureau of Economic Analysis, https://tradingeconomics.com/united-states/consumer-spending, first quarter 2019.
[3] Brian Wesbury, “Trade War Hysterics,” First Trust, Monday Morning Outlook, May 13, 2019
[4] Ibid.