Presidents Trump and Xi Trying for a Trade Deal, 2018
Global markets have been rocked this week by the news that President Trump has threatened to raise the tariffs on $200 billion of Chinese imports from 10% to 25% on Friday, May 10th (Ana Swanson & Keith Bradsher, 2019). As of Friday morning, President Trump has carried out his threat. Chinese and other Asian markets swooned during the week, with the Shanghai Composite Index falling 5.6% on Monday, May 6 th (Elaine Kurtenbach, 2019). The Shanghai Index bounced higher by 0.69% on Tuesday, but was down again Wednesday by 1.12%, and yet again Thursday, by 1.48%. Yet given the fact rather than the rumor, the Shanghai Index bounced over 3% on Friday. Meanwhile the US Dow Jones Industrial Average (DIA) dropped over 470 points Monday morning to start the drop off the right shoulder of a possible head-and-shoulders pattern (Chart 1), before rebounding sharply on rumors, ending with only a -66 point loss on the day. However, after the Monday May 6 th close, US Trade Representative Robert Lighthizer accused China of reneging on prior agreements and said the increased tariffs would definitely take effect on Friday (David Jackson & Michael Collins, 2019).
Chart 1: US Dow Jones Industrials ETF (DIA), 2016-2019
On Tuesday May 7th, it was confirmed that the Chinese trade delegation would still meet in Washington DC this week with US trade negotiators, in spite of the threatened increase in tariffs, but the Dow (DIA) nevertheless opened with a loss of -246 points, and by the close on Tuesday it had reached a loss of -473 points as trade war uncertainty continued. Wednesday the 8th saw a +2 point gain on the Dow due to oversold conditions, but Thursday’s market action saw another drop of -139 points, for a cumulative loss of -676 points for the week-to-date. Futures are down again Friday morning early, but not by much so far. There is the potential for truly significant market losses, since the tariffs were increased Friday morning (the 10th) and the trade war may expand even further as China retaliates. It is not clear that the continuation of the trade war is really fully priced into the markets yet (Michael Bloom, 2019; Ben Levisohn, 2019).
It has long been suspected that the Chinese would be very difficult to pin down on some of the issues most important to US negotiators and President Trump (Wayne M. Morrison, 2019). The issues deemed most important by US trade representatives and President Trump include the following: 1) the dominance of China in global supply chains; 2) massive support provided by the Chinese government to its private sector; 3) the huge bilateral trade imbalance that the Trump Administration believes “hurts” the US economy; 4) the contractually-mandated theft of American know-how and innovation by Chinese firms as a matter of Chinese policy; and 5) massive state-supported Chinese industrial espionage (Matt Peterson, 2019). But even if these issues could somehow be resolved by China and the US, there is no reason to have any faith in the Chinese actually honoring an agreement.
The Chinese have a long history of violating trade agreements essentially at will, as has been shown in the case of their non-compliance with the WTO’s rules over the last few years (Charles Hugh Smith, 2019; David Fickling, 2019). Furthermore, given China’s goals under their ambitious “Made in China 2025” project, and in view of their political situation as a totalitarian state, it is extremely unlikely that they would be politically or economically able to concede to the US on all, or even most, of the trade deal protocols demanded by the Trump Administration (Phillip Orchard, 2019). Indeed, they have apparently backtracked on a number of issues in the trade deal that had been previously agreed, using last-minute edits in the draft agreement sent to the US on Friday as the vehicle for signaling their change of heart (Sean Higgins, 2019). If they were trying to anger the president, they could hardly have chosen a better technique.
THE IMPACT OF FAILURE
So let’s evaluate what might happen if the trade talks completely collapse, all threatened tariffs are put in place, and President Trump has to face the apparent defeat of that particular plank in his mandate from the voters who elected him. You know, in the short term it is not necessarily true that this setback represents a political defeat for Trump. He mentioned it in a MAGA rally the other night to huge applause, suggesting his constituents wanted something done, but were not unrealistic in their expectations as to whether the Chinese would agree. Punishing China with higher tariffs is seen by many voters as an improvement over what went before, even if it isn’t optimal. Since the prospect of a verifiable deal was never as good as market bulls thought, and it was always known to be a long shot within the US Trade Delegation and probably even the White House, what will the actual impact of failure be?
First, since the bulls may prove to have been wrong, they will have to regroup, which implies that a bit more of a correction is in store. It appears to be well-underway already. David Rosenberg of Gluskin Sheff has pointed out that the two main pillars holding up the market rally have now been knocked out from under the bulls: 1) the presumption of an end to the trade war; and 2) the presumption that the Fed would ease policy substantially (David Rosenberg, 2019), allowing profits (and more importantly, stock buybacks) to stay at elevated levels. The downside may be more than 10 percent; indeed, this may be the trigger (excuse du jour) for the big sell-off that’s been anticipated by bears for some time. President Trump needs the markets to do well of course, but the time for a big market correction (if one must be accepted) is now, not in 2020, and Trump may just be willing to accept the short-term pressure a correction would impose on him politically, in exchange for having it behind him in 2020. That doesn’t mean it will actually be behind him by then, but he might possibly think it could be, in my opinion.
Second, although President Trump has generally sounded optimistic until this week, he has a history of walking away from deals (e.g., North Korea) and is unlikely to suffer any doubts about his decision to punish the Chinese for reneging on previously agreed terms. The question is, what will the Chinese do? Well, since they cannot realistically be expected to meet Trump’s terms, and since their economy is temporarily less unstable (in outward appearance if not in fact) than it was a few months ago, they may be willing to toughen their negotiating stance and stick with their backtracking proposals. This suggests either that no deal will be forthcoming, or that a faux deal, where everyone declares victory and nothing useful results, will be the final outcome. Trump risks all if he accepts a faux deal, and I would argue that he loses little in the short run if he doesn’t.
I submit that Trump wins with his natural constituents by imposing higher tariffs now, and even if he deploys the final $300 billion tranche of tariffs in the near future. He will of course lose standing with economists and business media, who rightly favor trade as a good thing for the economy over the long term (Kevin Wilson, 2016). However, these same people have historically seemed to favor trade at any cost, with not much attention paid to the main victims of globalization, i.e., the Middle Class (cf. Kevin Wilson, 2017a). Trump will actually score some points with the Middle Class by standing up to aggressive Chinese trade tactics and mercantilism. Although some of Trump’s followers will mourn the loss of trade volumes and the increased prices on imported goods that will naturally follow from the failure of the negotiations, it is not at all clear that this will cost him substantially in the voting booth next year. This is because many Trump followers are angry about the way China has taken advantage of American businesses.
Farmers (especially those with soy beans) will probably be the worst-impacted US group, so they may not be very happy with President Trump, and this is an important consideration (Rachel Koning Beals, 2019). Soy bean futures have indeed dropped sharply this week. But Trump has shown flexibility in getting bilateral deals to help offset economic damage to farmers, and he may be able to do something like that again, perhaps with partners like Japan or South Korea. In any case, the majority of the Middle Class, including both Democrats and Republicans, not only fear globalization’s asymmetric impacts; they also resent the unfair trade practices of the Chinese and want something done about it (Frank Newport, 2018). Americans may not actually object that much to the idea of higher tariffs on Chinese goods, in spite of the fact that most people (in both parties) favor international trade.
Americans also tend to fear the rise of China as a military power whose goals are transparently in (at least partial) opposition to the strategic interests of the United States (Kevin Wilson, 2017b). Many Americans are pleased that the US Navy is showing the flag in the South China Sea, based on the long-standing (200-year-old) US policy of enforcing freedom of navigation in international waters. In fact the latest surveys indicate that China is now viewed with a net negative approval rating by Americans (Richard Wike et al., 2018). The risk of war between the two countries is perhaps slightly increased from low levels by a failure to reach a trade deal, but the so-called “Thucydides Trap” has been over-hyped and this risk will likely remain rather low to moderate. Of course, this situation might change dramatically if civil unrest or a revolution (in response to China’s economic decline) were to suddenly appear imminent to the Chinese leadership, and they ended up in need of a scapegoat.
Third, the US economy (real GDP) will slow down by at least 0.25%, and perhaps by as much as 0.50%, as a result of the cumulative increase in tariffs in recent months (Michael Sposi & Kelvinder Virdi, 2018; Lizzy Gurdus, 2019; William Watts, 2019). President Trump appears to think this will be offset a fair amount by the revenues generated from the tariffs themselves, but those go to the government, not the economy (think of government as a giant black hole that sucks money in but doesn’t let any out). Anyway, the downside may turn out to be serious as we are already in an economic slowdown and could be on the verge of a recession (Kevin Wilson, 2019; Kevin Wilson, 2018). The impacts will not be minor in China either, where GDP growth may be trimmed by up to -1.50% in an already sharply declining economy (Chart 2).
Chart 2: Estimated Actual Vs. Official Chinese Real GDP Growth
On balance, I think President Trump wins with many Americans by taking a hard line against Chinese unfair trade practices. Farmers, an important voting block, may not be so sanguine. The opposition may use any economic decline against Trump during the election campaign of 2020, of course. A recession before the end of 2020 will hurt Trump’s chances whether there is a trade war or not. However, a recession is probably locked in at this point due to the effective 3.50%-5.25% rise in rates that the Federal Reserve brought on by use of increased Federal Funds Rates and Quantitative Tightening (Chart 3). This probably explains Trump’s anger and frustration with the Fed in recent months. It is not clear whether he can effectively sell his version of causation for a potential recession to the public. Indeed, some previous presidents like Carter and Bush 41 have paid a heavy price for periods of economic decline that coincided with election years. However, other presidents like Reagan and Bush 43 have sailed right through to second terms when recessions occurred early in their first terms, but were followed by decent recoveries.
Chart 3: Additional Tightening From “QT” (“Shadow Rate”) Boosted Effective Rates Much Higher Than Fed Admits
Election politics may yet force President Trump’s hand and induce him to back off a bit and accept some kind of faux trade deal. But populist politics is unpredictable and it is still possible that Trump will stick to his guns and the Chinese will stick to theirs, to the short-term detriment of the global economy. A global recession, which may be in the cards anyway, will almost certainly transpire in that event. I think investors should consider moving the weighting of stocks in their portfolios to a more defensive position if they haven’t already. Given the current long-term volatility since the January 2018 market high, the renewed sell-off from the most recent (May) market high, and the state of certain national economies (e.g., China, Europe, Japan, US), it makes sense to invest some money in a gold fund like SPDR Gold Shares (GLD), but only as a short-term hedging trade, not a buy-and-hold position. The I-Shares Gold Trust (IAU) is an alternative ETF that may be safer for those who want to hold it for a somewhat longer period of time. But the safest form of gold in the event of a true financial apocalypse is physical gold.
Also, for those discounting a possible near-term recession and bear market, some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (OTCRX) could be held to protect assets in the event of a much sharper market draw-down associated with deteriorating economic data. Those in a more defensive frame of mind because of the expected eventual market slide should also hold some long Treasuries, in spite of bearish arguments to the contrary, as a stock market crash would be hugely supportive of bond prices: examples include the Wasatch-Hoisington Treasury Fund (WHOSX), and the I-Shares 20+ Yr. Treasury Bond ETF (TLT). Goldman Sachs thinks investors should consider emphasizing the holding of service stocks such as Walt Disney Co. (DIS), AT&T Inc. (T), and McDonald's Corp. (MCD); the goods sector should be avoided since these stocks will be subjected to tariff increases (Mark DeCambre, 2019).
Disclosure: I am/we are long GLD, OTCRX, WHOSX, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.