U.S.-China Trade Conflict: Long-Term Market Disruption or Short-Term Noise?


John Micklitsch, CFA CAIA, President & Chief Investment Officer

The step backward in U.S.-China trade talks has unsettled markets. This has caused fundamental and technical disruptions short-term, but longer-term, fundamentals probably will be ok given the stakes for both parties. Below are a few data points and perspectives, as well as a revisit of the temporary versus permanent risk concept investors can resort to during periods of increased volatility that might be helpful in the current environment.

  • The S&P 500 Index was recently down approximately 5.6% from highs due largely to the breakdown in trade talks between the U.S. and China. Small cap stocks, as measured by the Russell 2000 Index, are off roughly 7.7% from their highs. Both indices are still up sharply for the year. Clearly, the trade issue has grabbed investors’ attention once again. In a flight to safety, the 10-yr U.S. Treasury yield has fallen from 2.53% to 2.25%. Valuation on the S&P 500 at current prices is approximately 15.9x forward earnings with a forward dividend yield of roughly 2.0%.
  • Recall that, on average, the S&P 500 experiences a decline of 10-12% about every year with the market still finishing in positive territory for the full year roughly 75% of the time. The wall of worry items that cause the declines are usually different and they always feel significant and unique to the moment, but businesses, the economy and policies adapt, which protects against derailment of the long-term, upward trajectory of markets when given enough time.
  • Estimates project that sustained tariffs could cost the U.S. economy 0.4-0.5% of real GDP growth as buyers at all points along the supply chain adjust. Tariffs artificially increase costs, slowing down the rate of consumption (and therefore the velocity of money), which causes a headwind for GDP. For China, the disruption costs are estimated closer to 1.0-1.5% in lost growth. China, however, is starting from a place of higher real growth versus the U.S. Nevertheless, China could see its GDP growth fall from the 6.0-6.5% level down to the 5.0-5.5% level. The U.S. could see 2.50-2.75% real GDP growth slip closer to the 2.0-2.25% level under a protracted conflict.
  • Most bear markets (declines of 20% or more) are associated with a recession and, while the figures noted above would represent a slowdown in the U.S. economy, they are not indicative of a recession at this point, in our opinion.
  • Because the U.S. imports more from China than China imports from the U.S. and the U.S. is the bigger economy, the U.S. is thought to hold leverage in the negotiations and some would argue the Administration is simply pressing its advantage now. On the other hand, China’s greatest point of leverage is time, as the 2020 election cycle looms and the Administration would most assuredly like the issue off the table well before then. Sensing this, the Chinese may be trying to extend the negotiation window to try to get a better deal. Time will tell who is bluffing. The next time it appears that Presidents Trump and Xi could meet face-to-face is June 28-29 at the G20 Summit in Japan.
  • A more ominous consideration for a quick resolution is if trade talks broke down because hard line members of China’s Communist Party have convinced President Xi that any deal is tantamount to 200 more years of humiliation at the hands of the West and that no deal is the best deal. With a population of 1.4 billion and a rising middle class, China needs access to the U.S. markets to create jobs and maintain political stability. That makes the no-deal route a challenge. Another bigger-picture consideration is that this is an emerging battle over global Internet/technology leadership itself and that, given the importance of advanced technology initiatives such as 5G, this dispute could usher in what some are calling a new technology “cold war” and a gradual shift from a G20 led world to a G2 led world focused on U.S. and Chinese policy.
  • The U.S. remains one of the most open and least-tariffed economies in the world. In some sense, that goes with being the leader of the free world. These talks, therefore, are probably more a recognition that China, as the world’s second largest economy, is all grown up now (and then some) and no longer needs a tilted economic playing field like other emerging trading partners or less-stable economies. Although the Chinese instinctively may sense the shift as well, a desire to preserve the status quo combined with their ability culturally to “save face” under the current negotiation framework is limited and may be contributing to the difficulty of the talks.
  • In terms of investment strategy, most successful, long-term investors tend to think of periods of volatility as buying opportunities at some point, especially as you get deeper into the pullback/correction.
  • While both sides appear to have retreated to neutral corners, the market continues to handicap that a resolution or further “stand-down” is possible, which would make the current impasse temporary if it played out that way. Even if it is not temporary, economic moderation is not the same as heading for a recession. Businesses and consumers adjust to economic conditions as does policy, including perhaps the FED’s willingness to lower interest rates to support the economy. Temporarily, however, investors’ desire for a higher margin of safety may spike until the new normal sets in, after which markets and individual companies can begin to rebuild their momentum. When you are living it, temporary can feel like a long time, but in the context of a long-term financial plan, it is not.
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