Last week saw an acceleration of the protectionist rhetoric between the U.S. and China. The week ended on a down note, with U.S. President Donald Trump tweeting a proposal for another $100 billion in tariffs, swiftly followed by China, despite its important holiday, promising to match the most recent round of tariffs and fight the U.S. “at any cost.” Following China’s threat, Trump admitted that the U.S. may feel some “pain,” while U.S. Treasury Secretary Steven Mnuchin conceded that, though unlikely, “there is the potential of a trade war.”
While we are far from a trade war at this juncture, the heightening trade tension is playing out just as I feared. In all honesty, I don’t see a compelling reason why China would make concessions to the U.S., especially given that senior White House officials, in an attempt to reassure concerned U.S. citizens, have said the U.S.’ threats are just a negotiating tool.
It’s been many years since the negotiations class I took in law school, but I’m pretty sure I learned that if your opponent knows you are bluffing, they are unlikely to concede. Adding to the unlikeliness that China will actually grant meaningful trade concessions is that the U.S. is pursuing this alone, without enlisting the help of other key trading partners, and that Chinese President Xi Jinping has consolidated his power and is arguably stronger than ever before. Sure, the Shanghai Stock Exchange Composite Index is down more than 10% from its January peak,1 largely on trade war concerns, but in general, Chinese citizens do not have a large portion of their net worth tied up in the stock market, so it seems the Chinese government may feel less pressure to make any meaningful compromises. To be clear, I’m not suggesting the U.S. is wrong in pursuing intellectual property violations; however, its approach seems to carry with it a low probability of success. This is particularly dangerous given that China can utilize non-traditional retaliatory tools such as devaluation of its currency or the cessation of some or all of its U.S. Treasury purchases – or an actual sale of its U.S. Treasuries.
Investors react to heightened volatility
Not surprisingly, U.S. investors took this protectionist threat more seriously this past week. Stock market volatility, which had fallen mid-week, rose by the end of the week. Emerging markets stocks also sold off while Asian stocks posted some modest losses.2 More indicative of investor fear was the dramatic flight into Treasuries last week – flows were the highest seen in more than two years. After rising mid-week, the yield on the 10-year Treasury moved lower and finished at 2.79%.1
Market sentiment has clearly soured. The critical question: Is a move to risk-off positioning justified at this juncture?
In order to properly answer this question, we must explore the two key drivers that have heretofore created an upward bias for stocks globally: 1) the improving global economic environment and 2) still-accommodative monetary policy.
1.Despite recent disappointments, data suggests the global growth story remains intact, but there are some significant blemishes. While the U.S. unemployment rate remained at its low level, the U.S. jobs report for the month of March was far from a Goldilocks scenario. The increase in nonfarm payrolls was relatively low at 103,000, but wage growth was relatively high at 0.3% month-over-month and 2.7% year-over-year. (Remember that wage growth is the metric in the jobs report that the U.S. Federal Open Market Committee [FOMC] follows most closely, given its potential to impact inflation. A continuation of this trend could cause the FOMC to raise rates four times this year versus three.)
In France and Germany, the Purchasing Managers Index (PMI) fell for March. In the UK, the manufacturing PMI clocked in at 55.1, while services reached just 51.7. In China and Japan, the PMI for both manufacturing and services rose for the month of March.3 But despite increases here and decreases there, it’s important to note that the numbers in all of these regions remain above 50, suggesting the continuation of economic expansion. And while the recently released Bank of Canada Business Outlook Survey indicates a slowdown in GDP growth this year, I was surprised to see business executives’ sentiment remains positive; I found this very significant given that Canada would likely be hurt by protectionism in general and the U.S. pulling out of NAFTA in particular. Far more important than sentiment are hiring plans, which are positive, and business investment plans, which remain solid (although they are down from the previous quarter). While the global growth environment has lost some momentum, it is still positive.
2.Monetary policy remains accommodative. In a speech last Friday, FOMC Chair Jerome Powell suggested that monetary policy normalization remains on course. Powell explained that it’s “too early to say” what effect a potential trade war between the U.S. and China would have on the economic outlook, and that he doesn’t see any implications “yet.” This makes sense – it would be impossible to form an outlook since we don’t know how this situation will play out. But this raises uncertainty about how the Fed might adapt if the trade situation deteriorates, particularly the potential for a slowdown in tightening – and that, by the way, carries with it the risk of policy uncertainty. Other than that, Powell’s message was that the labor market is strong and that inflation will come up – but neither seems to be at problematic levels. This suggested that, at this time, the Fed plans a gradual and measured pace of rate hikes. However, I continue to worry that data will indicate inflation rising enough to force the Fed’s hand in tightening more quickly.
Even though these two key drivers remain intact, that doesn’t mean there aren’t risks. I still believe the most likely risk is that monetary policy tightens more quickly than expected. (The epicenter of this risk is, of course, the U.S.). And tightening doesn’t only mean that rates rise more quickly than expected – the far greater threat would be an acceleration in balance sheet normalization by the Fed. In this environment, I do not believe an exodus from risk assets is warranted, but I strongly encourage broad and deep diversification. That may mean adequate exposure to both international and smaller-cap equities, exposure to a wide variety of fixed income sub-asset classes, and adequate exposure to alternatives that have low correlations with traditional equities and fixed income. Investors should talk to their financial advisor about the exposure that is right for their needs.
Looking ahead, here’s what to watch in the coming days:
- Tech watch. I expect more of the same March jitters for tech stocks as Facebook CEO Mark Zuckerberg testifies before Congress and markets contemplate greater regulation of some tech companies such as Facebook.
- Earnings watch. I expect earnings season to be strong, which should be positive for the stock market. As of April 6, 53 companies in the S&P 500 Index issued positive earnings guidance for the first quarter – which is far above the five-year average. And with just 23 companies already reporting first-quarter earnings, 74% reported a positive sales surprise as of April 6,4 I expect that trend to continue.
- Protectionism watch. Chinese President Xi Jinping will be speaking at the Boao Forum. The assumption is that he will dial down the protectionist rhetoric; however, I would not be surprised if that does not happen. We will want to follow this closely because, if Xi does not assuage investor concerns, we could see more market turbulence.