Let’s Make A Deal, China Edition
Since the correction that began in late February, the U.S. stock market has been laboring under many fears.
These fears fall into two basic categories — the rational and the irrational. A fear can be rational or irrational on its face; no one would call an investor “rational” if they spent time seriously considering the effect of zombies or asteroid impacts on their portfolio.
But more subtly, fears that are not that crazy could be considered irrational if they dominate an investor’s attention at a level far beyond their actual probability of occurring, or if they cause anxiety far out of proportion to the negative effects they would have if they actually happened.
Some of the most significant fears that have gotten a lot of press in 2018 as reasons for market volatility fall into this category:
• Government shutdowns;
• partisan gridlock;
• chaos in the White House;
• the impeachment of the President;
• a new Fed chair;
• an inflation spike;
• rapidly rising interest rates;
• some other central bank “policy mistake”;
• war in the Middle East or on the Korean peninsula;
• trade wars with China or Mexico.
Each of these has had a turn in the sun as “the” reason why markets corrected from their January highs and have since largely traded sideways.
None of these fears is obviously irrational. All are plausible. But most are unlikely, or if they did occur, they would be unlikely to cause the severe disruption that market participants seem to fear.
Really, as we have observed a few times in the course of 2018, the central dynamic markets are experiencing is fairly simple. Interest rates are rising after a multi-decade period that culminated in unprecedentedly low rates around the world — negative, in many places. Rising rates put downward pressure on stock valuations, as well as being difficult to digest psychologically because of the length of time that rates have been falling. On the other hand, profits are rising, which supports higher stock prices. Profits are the good cop; rates are the bad cop; the market is stuck between them.
The result, so far, after the reality of rising rates sank in by the end of January, has been a sideways market. Since the market is a discounting mechanism, it is looking out to the future and asking whether the profit growth now being observed will continue — or if, with rising rates, a recession cloud is becoming visible on the horizon. The resolution of this basic tug-of-war is yet to come. Until it does arrive, we can look forward to more volatility, and likely a range-bound market.
Ultimately, we believe at present that the majority of important economic, financial, and market indicators, as well as the established historical pattern, suggest that a final period of rally and exuberance lies ahead before the bull market that began in March 2009 finally ends. It may be that this rally is led by smaller U.S. companies, by non-U.S. companies, or by commodity-oriented stocks. The culmination of the rally could take place later this year, or more probably be delayed until 2019 or 2020.
In the meantime, the volatility will find ad hoc explanations and justifications in the media — which will often involve irrational fears. Volatility will ebb and flow as these fears are raised and as it becomes apparent that they’re unlikely to occur or that their potential effects have been exaggerated.
A Trade Truce After All
Although media have finally begun to acclimate themselves to the style of the Trump presidency, they are still not adept at reading the administration’s strategy. Partly this is because that strategy is so widely divergent from that of the administration’s immediate predecessors.
Since shortly after the 2016 U.S. elections, we have pointed out many times that the administration’s negotiating style would reflect the President’s business experience more than it would reflect the conventional negotiation models of previous administrations. The core of that style is to open negotiations with extravagant demands, and even with bluster and intimidation, and then moderate those demands as negotiations proceed. The hoped-for result is to reach a more advantageous settlement than would have been reached with a more modest opening gambit. Whatever one may think of the propriety of deploying this style in the context of high-stakes international political and economic relations, it is one that sometimes produces good results, and sometimes backfires, and we have seen examples of both since January 2017.
The “trade war” with China is a case in point.
We are politically agnostic. Our personal political views have no bearing on our analysis, which is simply directed to finding the best investment opportunities for our clients under current conditions. That means that if the media are creating anxiety, it’s our job to see beneath the surface, and objectively evaluate the fears: are they rational or irrational?
When trade war fears came to the fore in March, we determined that they were irrational — not in the sense that these fears were as outlandish as a zombie apocalypse, but in the sense that neutral analysis suggested that the risk of severely adverse developments was small.
First, we knew that Donald Trump had campaigned on addressing unfair trade practices, and his public record back to the 80s suggested that this was not a transient concern on his part, or one that he campaigned on just to appeal to a working-class voter base. After the election, we anticipated that trade negotiations with China would eventually be on the administration’s agenda, so we were not surprised.
Second, we recalled the administration’s negotiating style, which by March, 2018 we had already seen in action many times. We expected the administration’s negotiators to begin by placing enormous pressure on their Chinese counterparts. We expected outlandish rhetoric, extreme demands, and high-pressure tactics, so we were not surprised by these, either.
Third, we expected that President Trump, who stakes a great deal on personal contacts and relationships, would play up a personal connection with Chinese President Xi Jinping as a crucial element of his success in striking a deal.
Finally, we expected that when the actual negotiations got underway, the administration would yield those extreme demands in a way that would cause some hardcore anti-China politicians and policy wonks to believe the administration had betrayed them and betrayed its avowed principles. We expected that the administration would sacrifice extreme demands for the sake of reaching a settlement better than the status quo. We understood this because we have seen for a year and a half that the administration is not motivated by ideology; it is motivated primarily by the desire to be seen to “make good deals.”
U.S. and Chinese Delegations: Let’s Make a Deal
Over the weekend, U.S. and Chinese delegations announced a preliminary agreement, accompanied by a “truce” — with threatened trade actions put on hold while negotiators hash out the final shape of the deal.
So far, the whole negotiation process has unfolded as we anticipated it would. While the final deal will certainly not satisfy everyone, and will probably suffer more reversals before it is consummated, it will likely show some significant benefits for the U.S. There was apparent disagreement between the U.S. and Chinese delegations over the exact size of China’s commitment to reduce the trade deficit between the two countries; public statements from U.S. negotiators which were disavowed by the Chinese team probably represent another form of negotiating pressure. However we note two things. First, even if the $200 billion target for reduction of the trade deficit is just intended to set a high bar and put on pressure for the actual number that is eventually announced, each $50 billion increase in U.S. exports would likely result in a 0.25% boost to the U.S. GDP growth rate.
Further, increases in U.S. agriculture and energy exports to China could not do the heavy lifting on their own. To achieve even half the suggested target for trade deficit reduction would necessarily involve significant increases to manufacturing exports as well. After the weekend announcement, China announced that tariffs on imported automobiles from the U.S. will be cut from 25% to 15% on July 1 — a sign, we believe that further such changes are coming.
The statement also contained strong language about improvements to the treatment of intellectual property. While we don’t hold high hopes of fundamental change in this regard, we think some areas, such as forced technology transfer from U.S. companies to Chinese partners, could see real improvement.
The market’s response, though, has been tepid. Skepticism that the deal will be completed continues to rule the day. The tug-of-war continues — with fear of interest rates and skepticism about good news on one side, and strong economic fundamentals and strong earnings on the other.
Investment implications: The trade conflict that began in March between the U.S. and China is thus far playing out according to our expected script. Although a resolution is yet to be finalized, we think chances are very good that a final deal will be reached even if more reversals occur, and that even if it does not address all the U.S.’ demands, it will have positive effects on U.S. exports and on intellectual property rights for U.S. firms. Ultimately the deal will be good for U.S. manufacturers and energy and agricultural exporters to China.