Reality checks can be painful.
Yet even after a tit-for-tat on tariffs between the two economic superpowers—and President Donald Trump’s move to restrict Chinese telecom-equipment giant and national champion Huawei Technologies from possibly accessing the U.S. technology and semiconductor chips that it needs to operate—the U.S. stock market proved resilient. The
index was trading early on Friday afternoon at 2875, down 0.2% for the week.
So what is the reality here? We asked money managers, trade experts, and market strategists to put the trade-related risks into perspective. The consensus: put aside the playbook for a trade war and global recession for now, but be prepared for uncertainty and bouts of stock market volatility for months to come.
“The market has been overvalued, not paying attention to any risk; it has been priced for the best-case scenario,” says Rupal J. Bhansali, chief investment officer for international and global equities at Ariel Investments. “Now, it will take notice of any risk that materializes with a knee-jerk reaction.”
In other words, expect market swings as investors dissect tweets and economic data to gauge the next plot twist in the trade drama. Yet even then, there is reason not to hit the panic button. Both the U.S. and China are in a better economic position to withstand the latest tariffs. And the Federal Reserve and other accommodative central banks offer markets a cushion. Changing trade patterns, meanwhile, could reduce the impact of the trade dispute on the global economy.
“If you were ever going to impose costs on the U.S. consumer, the time is when unemployment is at 50-year lows and inflation is a pancake,” says Christopher Smart, head of Barings Investment Institute. “And it’s clear that the Chinese government has tools that work [to deal with tariffs]—and even more fiscal firepower than the U.S.”
In China, the trade dispute is feeding a wave of nationalism, with commentators comparing it to the nation’s humiliation by foreign powers during the colonial era—a longtime sore spot with the Chinese. That could complicate negotiators’ goals of pushing Beijing to make structural reforms, nailing down enforcement details, and working out thorny issues related to technology.
But the standoff over trade ranks low on the escalation scale, says Marc Chandler, a longtime currency analyst and chief market strategist at Bannockburn Global Forex. “It’s like children in the sandbox, still hitting and spitting at each other, not killing each other,” he says.
Moreover, the Wall Street consensus is that there will eventually be a deal with China. Many are looking to the meeting of the Group of 20 nations at the end of June as an opportunity for Trump and President Xi Jinping to de-escalate the situation, as the two leaders did last year.
*percentage of total sales
Sources: Barclays; Bloomberg
Even as such optimism holds sway, stocks could still fall: Bank of America Merrill Lynch strategists have forecast a pullback of 5% to 10% in the S&P 500 related to the latest round of tariffs.
That’s not to minimize the risk of a full-blown trade war, whose odds are rising but still low. Bank of America forecasts a 20% to 30% hit to the S&P 500 if the White House imposes tariffs on the rest of Chinese goods that would hit a wider swath of consumers and businesses. Also worth watching: if the moves by Washington to restrict Huawei draw retaliation from the Chinese and the strategic battle over technology spills into the trade war.
That would almost certainly provoke Chinese retaliation through boycotts of U.S. goods, currency devaluation, or increased scrutiny and regulations on U.S. companies operating there. It could spill over into geopolitics, through conflict in the South China Sea, disputes over Iranian oil, or North Korea issues. And that would mean recalibrating all sorts of expectations.
Strategists, however, see such a scenario unpalatable for both sides. Headed into the 2020 election season, Trump will want to talk up a strong economy and a bullish stock market, while Chinese leaders will want to stabilize their economy as the Communist Party celebrates its 70th anniversary in power.
Even if all $500 billion in
Chinese exports to the U.S. are subject to tariffs…
…only 2.4% of the U.S.
economy is tied to exports from China at risk for tariffs.
…and 3.7% of the Chinese economy is tied to exports to the U.S. at risk for tariffs.
Even if all $500 billion in Chinese exports to the U.S. are subject to tariffs…
…only 2.4% of the U.S. economy is tied to exports from China at risk for tariffs.
…and 3.7% of the Chinese economy is tied to exports to the U.S. at risk for tariffs.
Still, while a phone call between the leaders or a scheduled meeting of trade negotiators could cheer the markets, trade experts caution against expectations for a tidy resolution. As China tries to make the transition from being the world’s factory to being more competitive in higher-value manufacturing and technology, tensions between the two countries could persist, probably for years, as they try to coexist with different political and economic systems—and different strategic interests.
“The stock market now is just pricing in a few months of delay,” says Caroline Atkinson, who served as deputy national security adviser for international economics under President Barack Obama and now advises investment firm RockCreek Group. “I don’t believe any deal will be completely settled before the 2020 election. People need to get used to that idea of uncertainty.”
Here’s how the experts assessed the five biggest trade risks:
RISK: Trade tensions send markets into a tailspin.
REALITY: Stock markets might decline, but a more dovish Fed should offer a safety net.
The Fed’s turn from raising interest rates to becoming more patient and flexible in reducing its Treasury holdings has lifted investors’ optimism that the central bank is more likely to swoop in with a rate cut if things get dicey. But some strategists had already been recommending a more balanced portfolio in anticipation of bumpier times, as stocks have logged hefty gains this year and growth has softened. The trade escalation only adds to those calls.
In a note to clients, BlackRock chief equity strategist Kate Moore reiterated her recommendation to maintain “ballast in portfolios,” such as U.S. government bonds, while sticking with U.S. and emerging market stocks, and favoring companies that can grow even as economies slow, particularly in the U.S. health-care and technology sectors.
Other strategists have pared riskier assets from model portfolios, including emerging market stocks and bonds. They are taking a closer look at cyclical sectors such as technology and industrials, which rely heavily on China for sales, and manufacturing stocks, all of which could take a hit as trade tensions rise.
“Cyclicals were beginning to outperform as people were getting comfortable with the economy growing at a faster pace. The uncertainty around trade throws that into question,” says Jason DeSena Trennert, CEO of Strategas Research Partners. “We are overweight financials, industrials, and technology, and those last two are probably the biggest risk to our market call.”
Barclays equity strategists analyzed not just foreign sales but also import and export levels to identify stocks most vulnerable to trade tensions. Among those high on the list are
(ETN). Apple has become exhibit A for trouble in China. Much of its hardware is made in China, where it also generates about a sixth of its sales. Wolfe Research analyst Steve Milunovich estimates that increased tariffs could add as much as $150 to the average iPhone price and jeopardize as much as 20% of Apple’s earnings per share.
Retailers and their suppliers are also vulnerable, with
(NKE) high on Barclays’ list. More than a third of clothing imports and 70% of footwear comes from China; Cowen analyst Oliver Chen recently warned that retailers might not be able to pass on higher costs to shoppers, potentially cutting earnings per share by 10% to 30%.
RISK: Trade Tensions Bring Global Growth to Standstill.
REALITY: A trade war would hurt global growth, sapping business confidence and curtailing spending and investments. But some context is helpful: For the $21 trillion U.S. economy, even the full $500 billion in Chinese exports that could be at risk for tariffs is small—accounting for just 2.4% of U.S. GDP. China gets a larger share from trade, but even then, less than 4% of its GDP is tied to the U.S. China is increasingly trading with other emerging markets, not to mention shifting its economy to focus more on its own consumers, who account for about 75% of GDP growth.
Changing trade patterns have reduced global trade’s impact on economic growth—one reason that Sonal Desai, chief investment officer of Franklin Templeton’s Fixed Income Group, describes trade wars as “the dog that didn’t bark.”
Global Growth Less Reliant on Global Trade
The dek goes here
from 1992 to 2006
from 2011 to 2018
Global growth from 1992 to 2006
Global growth from 2011 to 2018
In the 15 years before the financial crisis, global trade grew at twice the pace of global GDP growth. In the decade after, global trade grew at a 20% slower pace than global GDP growth. Yet the global economy still grew at roughly the same pace—3.6% versus 3.7% when trade was stronger. That could mean the recent trade skirmishes have a more muted impact on global economic growth than some expect, Desai says. The International Monetary Fund forecasts that U.S. GDP could fall by as much as 0.6% while China’s GDP could fall by up to 1.2% if 25% tariffs were levied on all of the bilateral trade between the U.S. and China.
The impact depends on a range of factors, including how consumers and companies respond, Desai says. After the tariffs imposed in January 2018 on imported washing machines, the median price for a washing machine rose nearly 12% from its pre-tariff price of $749, according to a paper from the Federal Reserve Board and the University of Chicago. U.S. producers didn’t take market share, but instead raised their prices, too. That suggested that the U.S. consumer was healthy enough to spend even though prices rose, Desai says.
(WMT) on Thursday said that it would raise prices because of tariffs, but expected customers to absorb them, which could help preserve its profitability. If other companies have similar luck, inflation could rise. That could put the Fed in the difficult position of having to raise rates in the middle of a trade conflict.
RISK: China’s economy buckles under tariffs.
REALITY: About $5.3 billion on a net basis flowed out of Chinese equities in the past two weeks as tensions flared, according to the Institute of International Finance. The worry: that trade could derail China’s efforts to stabilize its economy.
When the threat of a trade war loomed last fall, China reported its weakest quarterly economic growth rate since the financial crisis, and sentiment was at rock-bottom among investors and business owners. China is on steadier ground now, following a wave of stimulus measures such as tax cuts, infrastructure investments, and looser lending standards, says TS Lombard economist Rory Green. And more stimulus is expected to cushion the latest tariffs, including possible subsidies for cars and appliances, and cuts to banks’ reserve-ratio requirements to spur more credit.
Companies making goods in the cross-hairs of the tariffs, such as toys or footwear, or that are part of technology supply chains, could suffer. And China would feel the brunt of a full-on trade war, with Chinese stocks possibly falling to 2015-16 lows, according to Bank of America strategists.
While at some point, too much stimulus will spook investors concerned about China’s long-term debt, it should boost consumption for now, helping domestically oriented companies.
Divya Mathur, co-manager of global emerging markets strategy at asset manager Martin Currie, is looking to add to those with strong franchises unaffected by trade or that are able to raise prices to offset tariffs.
Alibaba Group Holding
(700.Hong Kong), two stocks widely held by U.S. investors, could face near-term pressure as investors shed China-related stocks. But Mathur would use pullbacks to add to the companies, citing their long-term growth prospects, as they capitalize on the millions who use their platforms and reap benefits of investments they are currently making in emerging technologies.
RISK: China uses its currency as a weapon.
REALITY: A weaker currency could take the sting out of tariffs for China by making its exporters more competitive. But it could also escalate tensions with the U.S., which has accused China of manipulating its currency in the past. A stronger dollar would hurt U.S. exporters and multinational companies.
China’s surprise devaluation of its currency in 2015 sent markets tumbling and $700 billion in capital fleeing the country. Memory of that panic is still fresh in investors’ minds. Beijing, however, has taken steps to restrict capital outflows to prevent a repeat.
Plus, increased scrutiny by the U.S. of Chinese acquisitions, a Chinese push to keep investment local, and the recent inclusion of Chinese A shares and bonds in major emerging market benchmarks, which forces fund managers to invest more in the country, means more money sloshing around to give China some breathing room.
Still, a weaker Chinese currency could bring other emerging markets pain, hurting exporters in South Korea, Taiwan, and Thailand, and possibly causing those countries to weaken their currencies to stay competitive. A stronger dollar raises costs for countries servicing dollar-denominated debt and for those, such as India, that import dollar-denominated oil.
Investors becoming more risk-averse in the wake of the trade-conflict escalation could reduce emerging market holdings, leaving them open to further declines. The
MSCI Emerging Markets
index was down 2.2% as of Thursday’s close, reversing about a third of its rally this year.
But not everyone loses: Latin American agricultural companies could attract more orders as China tries to diversify its commodity sources, while Mexican manufacturers and Southeast Asian countries’ economies could benefit over time as companies shift production away from China.
RISK: China dumps Treasuries.
REALITY: Called the “nuclear” option, the fear that China would dump all or most of its $1.1 trillion in U.S. Treasury holdings resurfaces every couple of years. While China is the largest foreign holder of Treasuries, its holdings are small in the scope of the $22 trillion market, and buyers are plentiful—especially if fears of a global slowdown or geopolitical event mount.
“Where would they put the trillions of dollars? 10-year German Bunds are below Japanese 10-year yields; there aren’t a lot of options,” says Bannockburn’s Chandler. “They also don’t want their currency to appreciate, so that handcuffs them,” he says, adding that dumping would only hurt themselves. “China tends to find things to hurt adversaries without hurting themselves.”
Write to Reshma Kapadia at [email protected]