- Unexpected tariffs catch the market by surprise
- Sharp selloff accompanies escalating trade conflict with China
- While the negative consequences of rising trade friction are significant, there are a couple of positives which can help the market
- Most likely we will now enter a period of detente till the next trade meeting in September
- Panic selling will not be a prudent portfolio strategy, and investors can gradually diminish the risk exposure as the markets consolidate
Market Pulse
With the new month, a new scenery was rolled out which had a lot more red color.
The trade conflict between the US and China assumed an ugly turn as the situation deteriorated rapidly instead of improving or remaining constant as investors had assumed. After a trade meeting on Aug 1, that was characterized as constructive, the US broadened the tariffs to the remaining $300 billion of goods from China. This was unexpected and the market sharply retreated on Friday. As the market braced for a response from China, it arrived on Monday in a form which left no doubt that China was in no hurry to settle the dispute. The Chinese authorities allowed their currency to float lower thus weakening it against the dollar and in the process crossing a psychological red line of 7 yuan to a dollar, as well as halted further purchases of US agricultural goods.
The financial markets were blindsided by the severity and the speed at which last week’s trade negotiations dissipated into hostilities. In just two days, a favorably-leaning market environment, after the Fed rate cut, was transformed into a more uncertain and hostile one.
The China trade conflict and tariffs are a storyline that the market can adjust to and learn to work its way through with helpful nudging from the Fed in the form of loosening monetary policy. But an escalation comes with unintended consequences and potential miscalculation for no one knows the path of responses that the other party will take. With the global and US economy on a weaker footing, such actions can increase uncertainty which begins to undercut global growth.
A possible devaluation of the Chinese currency can have wide-ranging disruption leading to global economic dislocations. The dollar-yuan peg of 7 yuan to a dollar is the most important currency relationship in the world. It won’t be an overstatement to say that much of the world operates with that peg in mind. A simple backing-off by the Chinese central bank from further supporting the renminbi and letting market forces interplay would very likely push the currency meaningfully lower, keeping in mind the state of the Chinese economy. Any form of devaluation by the second-largest economy in the world will have a direct impact on trade and will cascade across the globe forcing many countries into a forced devaluation in order to stay competitive in the global marketplace.
The trade conflict between the US and China assumed an ugly turn as the situation deteriorated rapidly instead of improving or remaining constant as investors had assumed. After a trade meeting on August 1, that was characterized as constructive, the US broadened the tariffs to the remaining $300 billion of goods from China. This was unexpected and the market sharply retreated on Friday. As the market braced for a response from China, it arrived on Monday in a form which left no doubt that China was in no hurry to settle the dispute. The Chinese authorities allowed their currency to float lower thus weakening it against the dollar and in the process crossing a psychological red line of 7 yuan to a dollar, as well as halted further purchases of US agricultural goods.
The financial markets were blindsided by the severity and the speed at which last week’s trade negotiations dissipated into hostilities. In just two days, a favorably-leaning market environment, after the Fed rate cut, was transformed into a more uncertain and hostile one.
The China trade conflict and tariffs are a storyline that the market can adjust to and learn to work its way through with helpful nudging from the Fed in the form of loosening monetary policy. But an escalation comes with unintended consequences and potential miscalculation for no one knows the path of responses that the other party will take. With the global and US economy on a weaker footing, such action only pushes the case for the US and global slowdown and recession.
A possible devaluation of the Chinese currency can have wide-ranging disruption leading to global economic dislocations. A simple backing-off by the Chinese central bank from further supporting the renminbi and letting market forces interplay would very likely push the currency meaningfully lower, keeping in mind the state of the Chinese economy. Any form of devaluation by the second-largest economy in the world will have a direct impact on trade and most likely will lead to a forced devaluation by a broader group of countries in order to stay competitive in the global marketplace.
Upside
Trade Resolution
The events in August can be a dose of reality for both the US and China. The risks, both political and economic, are now much higher for both countries. In the case of the US, the argument that our economy is better than China and so can withstand economic shocks much better should begin to lose its appeal when the already declining growth rate of 1.5% is further threatened by such an unexpected escalation. Recessions or an economic slowdown during elections can make it harder for Presidents to get re-elected. And that’s the economic situation one will encounter if the trade friction keeps escalating. In the case of China, its ambition to be a global superpower will be considerably hampered if the current slowdown deteriorates into a recession. This time it will be harder for the Chinese government to once again spend its way out of an already debt saturated economy while being engaged in a trade conflict with its largest trading partner.
Thus, an escalation of the trade dispute this month may now create more motivated parties who arrive at the next meeting, realizing that another round of escalation will be even more punishing and push the situation to the brink. The key assumption here is that rational behavior will guide the approaches of both US and Chinese authorities, which hopefully will not turn out to be too much to ask for.
Federal Reserve & Monetary Policy
At the last rate cut meeting on July 31, the Federal Reserve ((FED)) Chairperson characterized the rate cut to be a mid-cycle adjustment, a viewpoint which differed from that of the financial markets, who anticipated it to be the beginning of a rate cut cycle. The escalating trade conflict will contribute towards bringing around the Federal Reserve to the market’s viewpoint.
A material increase in economic risk from the trade friction this month raises uncertainty and negatively impacts business confidence. In the absence of a resolution, the higher threat now to economic growth from the escalating trade conflict should sway the Federal Reserve to cut rates again in September.
The meltdown in treasury yields and disappearing earnings growth are quite firm indicators of an economic slowdown and worse. The 10-year yield has plummetted from 2.08% to 1.73% in a week’s time as of yesterday’s Monday close, underlying the rising risk to growth. This further boosts the argument for aggressive intervention by the Fed now, particularly as there is strong academic research that when there is less room to cut rates (only 2%), then a hefty dosage of easing early-on can be more impactful. If the Fed follows through it will be supportive for valuations.
Sell Or Hold – An Investor Dilemma
The volatility was so sudden and sharp on Friday and then Monday, that most investors would not have had time to adjust the portfolios prior to the correction. It is a difficult situation for investors to be in and is psychologically made worse by a sudden surplus of opinions in the media that now begin predicting even steeper declines.
The trigger event for the sharp retreat over the past 2-days was the imposition of a new tariff and counter-response. This has been a major negative for the economy as an escalation compounds business uncertainty.
While the risk of a further escalation remains, it most likely is a lower probability event in the near-term, in our opinion, as both parties appear to have communicated their messages through their actions prior to the next meeting in September. So it is highly probable that further actions deemed as escalation will not occur till the next meeting, although the rhetoric can be louder. If we look at the history of this trade friction since 2018, a period of tariff-slapping has been immediately followed by a period of detente. There is no reason to believe that the pattern will not repeat, thus allowing stocks to consolidate and find their feet again.
A de-escalation can possibly be just as swift as the escalation was. All it can take is a benign tweet from the White House. In the meantime, focusing on the yuan exchange rate, which the Chinese central bank sets every morning, will become a closely watched data point. A market worried about every decimal point on the exchange rate is a recipe for trouble and can invite sharp volatility.
What can be deemed as a further escalation on the part of the US will be the raising of the tariff rate from 10% to 25% on $300 billion of Chinese imports. While on the part of the Chinese authorities it will be an escalation to allow further slippage in the value of yuan beyond the psychological peg of 7 yuan to a dollar.
For investors, it may not be in their best interest to engage in immediate panic selling. Assuming that the likelihood of further escalation until the trade meeting next month is low, a more prudent strategy will be to reduce the portfolio exposure over time to align with the risk management approach. Markets tend to overreact on both ends, and patience during periods of high volatility can lead to better outcomes.
The events of the past two days cannot be underestimated. The market is sensitive to anything that can further disrupt economic growth. The risk of a US economic slowdown has risen. Getting trade deal resolutions have been harder than what the administration anticipated. That has been true with NAFTA and European trade deals. China will be harder.
The article was submitted for publication on Seeking Alpha on Monday, Aug 5, after market close.
