Yesterday the US stock market touched all-time highs during the late morning, only to fall back on political news concerning the White House, the Mueller investigation, the usual Twitter traffic coming from both sides of the political landscape. It was just another day in the ongoing drama that has kept us fascinated with a mix of strong economic data and divisive political banter. The challenge so far in 2018 has been to separate the fact from the fiction, discerning what is important from what is only noise. It has been an interesting year.
In 2018 the US economy has been firing on all cylinders, with unemployment below 4%, strong productivity and profitability, and consistent performance across all sectors of the economy. While there have been some headlines that contributed to volatility, on the whole, the market has remained solid. Tax cuts have fueled investor optimism and corporate profits, inflation seems to be under control, and the Fed is slowly raising interest rates, indicating its confidence in the pace of US economic growth and sustainability.
So, what’s all this about a Trade War?
Just when things seemed to be going almost too well with the economy, the White House announced new trade tariffs on steel and aluminum. The announcement took everyone by surprise. We later realized that this was the beginning of several rounds of tariffs that seemed to be aimed at some of our best trading partners. The tariff announcements came in waves and targeted the Europeans, then our friends in Asia, and finally China too. We even found ourselves in a row with the Canadians and Mexicans. The initial steel tariffs moved to other products, including automobiles, consumer goods, and raw materials. Retaliation by those the US targeted was swift and focused. American agricultural exports were slapped with tariffs against soybeans, grains, pork and beef.
The news after several weeks of trade war seems particularly bad, with predictions of rising prices, shortages of some goods and overstock of others, with dire risk to the economy, both in the US and around the world. Politicians are talking tough, defending their turf and vowing to limit foreign dumping of cheap goods into their domestic markets at the expense of home-grown products and jobs. Each week we hear another round of tariffs proposed, followed by retaliation tariffs from the other side. The trade war seems to be in an unending spiral of blame and accusation.
In just a few months, US trade policy has moved from a series of broad multi-regional trade agreements to name calling and threats. The Chinese, Canadians, Mexicans, and Europeans have each in turn been singled out by the White House for unfair trade practices and found their trade agreements abandoned and tariffs proposed. The headlines on the internet and the news tell us that this trade war will end in disaster, but through it all, the US stock market moved to all-time highs...how can that be?
A little history
Since 1995 the US has been part of the World Trade Organization (WTO) which governs more than 98% of US international trade. There are 164-member nations in the WTO who use a set a rules to govern international trade that were developed from the General Agreement on Tariff and Trade (GATT), a protocol set up following World War II to encourage both trade among democratic nations and alignment with the US against the Soviet Bloc. The rules of GATT never anticipated the inclusion of countries with centrally planned economies and largely relied on a freely functioning trade group where the free flow of goods, services, and capital would encourage a system that was largely self- regulating and free of barriers.
In the last two decades, the addition of Russia and China to the WTO assumed that reform of previously socialist economies along a free market model would help both countries nurture their developing economies. Instead, China in particular has used the WTO to foster its export economy while placing tariffs on imports to discourage competition. These tariff protections make it difficult for US firms to compete within China but vulnerable to Chinese exports competing with the US. The current Trade War is the result of the White House’s recognition of this situation and its strategy to address unequal trade policies.
Why now? It seems like everything was going so well.
With the swift growth of the Chinese economy, trade policies have created ballooning US China trade imbalances. China’s average tariffs on imported goods are 150% higher than those imposed by US. This means Chinese companies compete in the US market with relative freedom while US firms are shut out of the Chinese domestic market. China is now the world’s second largest economy and these tariff protections no longer make sense.
As we mentioned earlier, the US stock market continues to churn higher, even in the face of uneven politics. The US economy is currently experiencing a strong run that is insulating the US economy, in the short run, from the consequences of the trade war. Conversely, China’s economy is still very dependent on exports as its domestic economy develops. China has real incentive to find a solution to the trade war.
How will this all be Resolved?
The current trade negotiations are like nothing we have seen before. Past trade agreements were conducted largely in closed meetings by faceless teams of experts and details were very few. This round of negotiations reflects the current US administration’s unconventional style that relies on very public demands and threats with concurrent concessions and offers of compromise. While it is difficult to differentiate between public “haggling” and real policy positions it seems that all sides are actively participating in the search for a trade deal.
There is certainly list of things that could go wrong. The White House’s negotiating strategy is both confrontational and threatening. There is a risk that tensions escalate, but recent indications from the European Union, Mexico, and even China have been positive. While declaring their own tariff policies in response to US moves, behind the scenes both the US and its trading partners seem focused and keen to strike a deal.
Recent news from China indicates pressure in the Chinese economy, stock market, and real estate market from the trade problems with the US. Due to China’s export focus, there is a strong incentive to reduce the trade barriers that have been erected in the last few months. Likewise, in the US, the upcoming mid-term elections are both an opportunity and deadline for the White House’s strategy to continue the strong US economic narrative.
European Commission President Jean Claude Juncker’s recent visit to Washington resulted in a broad agreement to work toward zero tariffs between the US and the EU. NAFTA renegotiations with Canada are on hold, but statements by both the US and Mexico indicate they are working toward a deal. And finally, this week a delegation of Chinese trade negotiators is in Washington to reopen talks.
Ok, so where are we now?
All in all, current economic measures are good. US and Global economic trends are showing steady growth. The US stock market is deliberately extending the upward trend of the past 20 months and media reports have now begun to report on the “longest bull run in history.” Investors are excited about synchronized global growth and trade reform. The US economy is in a sweet spot relative to employment and productivity. For these reasons, we do not see a recession or market crash in the near future.
However, while there are no clouds on the horizon it would be unrealistic to expect this to continue forever. We are preparing for one or two market pull-backs (more than 5%) in 2018, with one of those pullbacks as much as 10% during the next 12 months. Investors would view this as a healthy opportunity to take profits and it is likely that a correction would rebound to even higher highs.
So far in 2018 there is a lot to be positive about, but market history tells us that trends persist until an event triggers an adjustment. When the trigger event occurs, market momentum does not turn on a dime, but may take weeks to develop a new course. We monitor indicators that have strong correlation with past market extremes and we remain encouraged.
Remember, patience is always the best investment.
God bless you,
Ed & Branson
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