Trade War…Again! Our Thoughts

In last week’s investment insights we wrote about our concern that the equity market was pricing in perfection and outlined three catalysts that could cause a pullback in the equity markets in the near term (i.e. complacency, seasonality and valuations). The one risk that has always been looming but we did not see as an immediate threat was a breakdown in the U.S./China trade talks. Our base case has been that the U.S. and China would come to an agreement on trade before it escalates into a full blown EXTENDED trade war (where the U.S. is placing tariffs on all imports from China). However, we do acknowledge that this upside risk has declined after the surprising last minute breakdown of China/U.S. trade talks. We provided some thoughts on the recent developments on  trade and discuss our current positioning.

  • Current tariff estimates on GDP: Today China announced additional tariffs to take effect on June 1. While President Trump has threatened to tariff more Chinese goods, it is not official at the time of writing. The $200 billion put in place on Friday is still a fraction of U.S. GDP and should have a minimal DIRECT impact to GDP even if the tariffs remain in place for a prolonged period of time. The IMF estimates that it could shave 0.2% off of U.S. GDP (potentially more if there is a hit to confidence) and other street Economist’s put the hit from 0.25%-0.50% but it is dependent on how long the “skirmish” goes on, the retaliatory measures China takes and the impact to confidence in the US.
  • China has less to retaliate with but more power to cushion the blow: At this time China has a small amount of U.S. goods left that it could tariff. So the U.S. has the upper hand in regards to slapping tariffs to force them to the table. While China owns ~$1 trillion of Treasuries, its U.S. dollar based reserves amount to over $3 trillion USD. They can not unwind this as a form of retaliation without destabilizing their own currency. In addition, with global sovereign rates near zero (and even negative) there are limited options for China outside of U.S. Treasuries. From a growth perspective, the hit to China GDP would be more significant than the hit to U.S. GDP. Bloomberg expects the new tariffs could reduce China’s GDP by almost 1%. However, China also has more ability to offset a hit to GDP than the US. China may implement additional stimulus measures and/or devalue their currency to offset the tariffs. In contrast, Strategas Research Partners is estimating that the tariffs and any retaliatory measures in the U.S. may erase the positive impact in 2019 from the U.S. tax reform package.
  • Rate cuts back on the table: The probability of a Fed rate cut by year end was reduced after solid employment data to a 50-50 chance. However, after the market volatility and recent trade developments, the probability of at least one rate cut by year end rose to 67%. It is a little early to speculate the effect but we believe it leaves the Fed on hold at a minimum.
  • Expect volatility. Last week the VIX Index saw its largest one week gain since December of last year. Right now equities are taking their direction from rumors and/or tweets as the talks take place behind closed doors. This is dangerous, especially since the next meeting on trade has been said would happen but the official date is still unknown. We will continue to focus on fundamentals and try to filter out the noise that may disrupt economic reports as the tariffs filter into data on orders, shipments and confidence, especially if this goes on for a  prolonged period of time.
  • Earnings at risk. While another round of trade disputes may not have a DIRECT impact to GDP since trade is a small portion of our GDP, the outlook for earnings becomes more uncertain the longer the “skirmish” continues. Since the S&P 500 P/E (NTM) had increased ~20% YTD on optimism about trade and a better than expected 1Q19 earnings season, a further valuation correction is likely as there is speculation on the tariffs impact on earnings.
  • Verdence view: Currently, we hold a high cash position because the equity market already looked expensive. We are neutral/modestly underweight U.S. equities with a focus on small/midcap. However, our biggest risk is our overweight to international equities, especially Asia. We would rather not make hasty decisions on speculation or rumors. Instead we will focus on facts but be ready to reduce this exposure if the trade battle looks to threaten fundamentals.