Trade Tensions: A Phase or the New Normal?

Jeff Mortimer

In his latest Investment Update, Jeff Mortimer takes a closer look at how the trade dispute has impacted both countries and what the partial trade deal may mean for the markets moving forward.

Tensions between the U.S. and China had been escalating before the recent round of trade talks in Washington, D.C. where a partial, “Phase 1" deal was agreed to in principle. Let's take a closer look at how the trade dispute has impacted each country and what the partial trade deal may mean for the markets moving forward.

China's Faltering Economy

China's economy continues to slow. Many of the reasons for the sluggishness are secular, including an aging population and the increasing public and household debt loads. Although China has taken steps to mitigate these issues, including modifying their “one child" policy in an attempt to raise the country's birthrate, they have made little headway.

From an economic standpoint, the amount of fiscal and monetary stimulus has not been aggressive enough. These efforts have only slowed the deceleration, they haven't accelerated growth. Specifically, China's industrial production growth rate was up more than 20% year-over-year in 2010 before falling into the teens during 2011. It continued a steep decline to about 6% in 2015, where it held steady before rebounding to 9% earlier this year, perhaps due to increased spending intended to offset upcoming tariffs. Since then, it fell to a 17-year low of 4.4% in August, before improving slightly in September. China's real GDP sits at 6.0% year-over-year through the third quarter, down from 6.2% in the second quarter.

China's official manufacturing Purchasing Managers' index (PMI) came in at 49.8 in September. This marks the fifth straight month of contraction. With China's economy comprised of roughly 20% exports as a percent of GDP, one can clearly see the impact tariffs are having. China's consumer is also starting to struggle, as evidenced by a decline in retail sales growth, which slowed to 7.8% year-over-year in September after a high of 9.8% in June.

The U.S. Economy Is Slowing, but the Consumer Remains Resilient

U.S. economic growth is also slowing, but not as much as China. The U.S. economy is holding up fairly well thanks to a healthy consumer and a solid labor market. The most recent employment data, with an unemployment rate of 3.5%, depicts a healthy job market. While somewhat below expectations, the 136,000 jobs added in September remain impressive given we are in the longest economic expansion on record. Consumer confidence has waned slightly from recent all-time highs, but current levels still indicate a fair degree of optimism, which should bode well for spending going forward. Retail sales and housing also remain relative bright spots in our economy.

Manufacturing in the U.S. is a bit of a different story, as the most recent manufacturing PMI data show a contraction, with recent readings falling below the key level of 50. Keep in mind that just over 10% of the economy is exports; the consumer accounts for 70%. Still, I believe that uncertainty around trade continues to be one of the major reasons for the softness in manufacturing.

U.S. vs. Them

While the U.S. economy may have the upper hand relative to China, continued trade and tariff issues still have the ability to drive the global economy into recession if they remain unchecked. Trade, tariffs and the realignment of supply chains around the world are already having an impact on global growth. Global manufacturing metrics seem to be indicating that the world is on the verge of a manufacturing recession. Continued tit-for-tat tariffs have the potential to bring about a global recession.

So with the potential for global recession on the line, why aren't the two sides able to find some common ground? The short answer is that, for both sides, it is about more than just economics. The U.S.'s hard line in trade negotiations threatens China's ascendance as a global superpower. For the U.S., this trade war is not only about tariffs, but also about unfair business practices, national security concerns, forced technology transfer and intellectual property theft. China has only recently acknowledged these concerns. These U.S. demands have made China's plan to realize its ascension much more difficult.

Phase 1 of the trade deal postponed an increase in tariffs planned for mid-October in exchange for China agreeing to purchase $40-50 billion in agricultural goods (although this deal seems to be fluid, depending on which side is talking). However, it fails to touch upon all the larger, strategic issues. So while this trade truce has soothed market sentiment for now, we'd need to see further progress on some of these other, more challenging issues for us to change our economic outlook for slowing global growth.

The New Normal

Markets seem to be nostalgic for the old days, when comparative advantage and free trade were the norm. That is why markets continue to rally on good trade news and slump when there are setbacks in negotiations. Unfortunately, this is likely to continue for the foreseeable future. This trade war is also likely to persist regardless of who is in the White House after the 2020 election, as both parties seem to believe that the U.S. should maintain a tougher stance toward China.

Trade-related volatility in the markets is unlikely to abate, if for no other reason than the market's lack of practice in discounting (that is, correctly pricing) trade wars. It could be argued that the last significant trade war took place in 1930, at the beginning of the Great Depression. Markets therefore may be apt to react negatively to trade war rhetoric at first, asking questions only later. Investors might need to become accustomed to this.

As long as there are no major shocks to trade and tariff issues, markets should slowly adapt to this new normal over time. Our neutral equity stance is a manifestation of this view. Perhaps on the other side of this wrangling, somewhere after many mini-deals and fits and starts have subsided, a much better outcome exists: a world with lower tariffs and fewer trade restrictions. We believe the path to better outcomes may be longer, and bumpier, than most may currently believe.


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