The market was caught off-guard when an anticipated trade agreement between the US and China has become a trade dispute. This led to a sudden increase in volatility and a drop of 4% in the S&P 500 index to start the first couple weeks of May. First, the prospect that a trade deal with China wasn’t imminent and secondly from the apparent Chinese opposition to what appeared to be previously agreed upon terms. Both sides have increased the amounts of tariffs and have to deal with the fallout of how this dispute affects their respected economies and constituents. The IMF has estimated that the trade dispute could negatively impact U.S. GDP by -0.60% and Chinese GDP by -1.50%, assuming an additional set of tariffs are put in place on an additional $300 billion on Chinese goods. Other estimates vary and some are larger. Nonetheless this dispute is unlikely to result in a U.S. recession.
The U.S. has several things going for it that may be allowing the strong position from which President Trump is negotiating. Small business optimism remains robust. First-quarter GDP grew at a faster pace than expected at 3.2% after growing 2.9% for all of 2018. Consensus expectations for 2019 GDP is between 2 and 3% (a level that we agree with). Unemployment is at its lowest level, 3.6%, since December 1969. And its been below 4% for 14 consecutive months – all while inflation appears muted. This is typically considered a goldilocks scenario when inflation is low and growth is moderate. In fact, this fairly tame inflation environment has led the Federal Reserve to communicate that they are “comfortable” leaving rates where they are. And the S&P 500 remains at or close to all-time highs.
China has been slowing for several years, as its economy continues to transition to one fueled from infrastructure and manufacturing to one based on organic consumption. Most recently, reports show continued slowing of retail sales and industrial production. The concern for Chinese authorities is that these recent trade tensions will further exacerbate the slowdown there – and this is coupled with a modestly slowing global economic backdrop. China has responded by easing financial conditions fairly aggressively and cutting tax rates.
Some have observed that President Xi Jinping is under a certain amount of pressure due to the Communist Party’s long-term growth target of doubling 2010’s GDP by next year. But China has historically been able to take a very long term approach to investing. Without a 4 year Presidential election cycle, Xi has no urgent need to settle a trade dispute to secure his own political future, although there have been some rumblings behind the scene. With the U.S. further escalating tensions by blocking Huawei’s products from being used in U.S. networks, there appears to be no imminent trade settlement coming. While the U.S. already had in place restrictions on federal agencies from using Huawei’s products and has strongly encouraged allies to avoid them as well, this additional step up in escalation suggests a much broader and longer road to dispute settlement. China has vowed to fight back in this trade dispute and is adamant about protecting what it sees to be as threats against its sovereignty.
In the U.S. the farm community and industry are feeling the effects of this dispute. Commodity prices continue to be under pressure and have been for several years now – please see the accompanying five-year chart of the Bloomberg Agriculture Index – this composes futures prices on coffee, corn, cotton, soybeans, soybean oil, soybean meal, sugar, and wheat.
The American farmer has been a big supporter of President Trump and polls suggest they remain so. It will be interesting to see how this plays out over the next couple of quarters, as it may mean a compromise is a better solution than soybean and corn prices falling further.
U.S. consumer price inflation could rise by 0.1% to 0.4% due to the tariffs according to economist estimates. This along with the very low level of unemployment may be why Fed Chair Powell recently said the current low level of inflation may be “transitory.” The bond market, however, is actually pricing in about a 75% chance of Fed rate cut before year-end – an example perhaps of the wisdom of crowds? Time will tell.
The financial markets always have something to worry about – the proverbial “wall of worry.” This trade dispute with China is a fine example of something that looks like a significant road block for our economy and the markets. But this country’s economic resiliency has been remarkable throughout our history. An excellent book on this subject by Dr. Alan Greenspan and Adrian Wooldridge called Capitalism in America: A History was recently published and well worth reading.