As Trade War Ramps Up, Falling Treasury Yields Support Stocks For Now

Summary

Tariffs on Chinese imports to the US are scheduled to ramp up to levels not seen since the 1930s.

Plummeting interest rates have provided support to a falling stock market.

2020 could be a very bad year for stocks if the trade war continues.

Free trade and globalization have contributed to lower inflation and steady economic growth over the past 40 years. The US plans to return to a level of protectionism not seen since the Tariff Act of 1930. If tariffs on China reach the proposed levels next year, it could result in either unexpected inflation or reduced corporate earnings. As of yet, stocks have been supported by ultra-low interest rates. Long-term Treasury bonds have outperformed the S&P 500 over the last year. I recommend reducing exposure to equity until trade tensions subside.

New tariffs of 15% on $112 billion of imports from China went into effect on September 1. The list of impacted goods will affect the consumer more than previous tariffs, meaning more potential for inflation or weaker consumer spending. There are also further tariff increases planned for October and December. Total tariffs on imports as a percentage of GDP are presented in the following charts. (actual, projected for 2019-2020)

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Data from US International Trade Commission and St. Louis Fed

Charts showing tariffs as a percent of total imports are all over the web, but it is also important to note that imports as a percent of GDP have risen substantially in the past 90 years. As a result, expected tariffs as a percent of GDP are likely to increase in the next year to levels not seen since the Great Depression. This is important when assessing the likely economic impact of the trade war’s current trajectory.

Business spending is already showing weakness

The current tariffs on China have already caused a significant decrease in business confidence and a reduction in capital spending plans. The IHS Markit Flash US Manufacturing PMI recently came in at 49.9, the lowest level since September 2009. Net domestic business investment fell 9.5%, from 2019 Q1 to Q2, but is still higher year over year. Business investment is a leading indicator for the economy and typically precedes consumer behavior.

Source: St. Louis Fed

Consumer spending is still strong for now

However, consumer spending has not seen signs of weakness yet, and the overall economy is still expanding. The Atlanta Fed’s GDPNow is estimating that 2019 Q3 GDP growth will come in 2.04%, while the St. Louis Fed is predicting 2.97%. The Conference Board Leading Economic Indicator Index for July suggested moderate growth in the second half of 2019.

Bond investors are clearly starting to worry. The 10-year rate inverted with the 2-year and the probability of recession in the next 12 months has jumped to over 30 percent, according to the New York Fed’s model based on Treasury spreads. The Cleveland Fed is predicting GDP growth of 2.3%, but estimates the probability of recession in the next year to be 44%. Money market funds are seeing increasing inflows, and TrimTabs Investment Research recently reported that corporate insider selling has reached levels not seen since 2007.

Quarterly flow of funds to Money Markets

Source: St. Louis Fed

Bloomberg estimates that a 25% tariff on all US-China trade will reduce global GDP by roughly 1% next year. Global real GDP growth is currently 3.6%, and advanced economies are growing at 2.2%. With current tariff rates as they are, I believe it is unlikely that the US economy expands by more than 2% in 2020.

The Chinese yuan has weakened against the dollar by over 10% since January 2018 when the trade war started. Any further weakening of China’s currency could offset much of the effects of tariffs on imports from China, but it also weakens demand for US exports to China and lowers profits for US companies operating in China. In addition, other possible Chinese retaliations include boycotts on US brands, dumping US Treasuries, and limiting exports of rare earth minerals. All in all, there will be no winners in this trade war.

When Trump was elected, interest rates and stocks rose abruptly on expectations of fiscal policies supporting growth, such as tax reform and decreased regulation. The corporate tax cuts enacted in December 2017 contributed heavily to the stock market’s gains in 2017. In March 2018, Trump put tariffs on steel and aluminum imports and chief economic advisor Gary Cohn resigned. Trade disputes started to come up with almost every trading partner to the US after that - China was the top target.

Anxiety about trade, rising interest rates, and a government shutdown all contributed to a market sell-off from October to December 2018. The market rallied again in January after the Fed indicated it had stopped raising interest rates and was considering lowering them.

From November 2016 through late 2018, as interest rates went up, the market underperformed compared to how it would have if interest rates had been held constant. The change monetary policy caused the market to perform much better in 2019 than what would have likely happened had the 10-year Treasury rate remained constant. The expectation of coming interest rate cuts has supported the market fairly well through the recent sell-off and kept the S&P 500 above its 200-day moving average.

Another way to think about the impact of changes in interest rates on the market is to look at the relative performance of the S&P 500 (SPY) and long-term treasury bonds (TLT). As interest rates fall, they drive asset prices up, and vice versa. Many factors influence the change in stock prices, but changes in interest rates are the primary driver to performance of the TLT fund. By reducing the return of the S&P 500 by the return on TLT, you get a proxy for what may have happened had interest rates remained flat.

Conclusion

The relative performance of these two assets represents benefits of a popular "risk-on" bet (SPY) vs. a popular "risk-off" bet (TLT). The "risk-off" bet has paid off so far during the trade war, as TLT has outperformed SPY by roughly 15% since Gary Cohn resigned on March 6, 2018. It is my opinion that the S&P 500 will likely continue to underperform other asset classes as long as the trade war continues, and I expect it to continue. With the market near all-time highs, it may be prudent to take some money off the table.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.