“Trade” Winds are Blowin’…Economic Foundation is Firm, Though

Trade has suddenly become the ‘four-letter word’ that no one likes to hear. The recent protagonistic trade barb tossed at China by the Trump administration has served the purpose of also poking a jagged stick in the eye of the investment market, which does not like sudden and unexpected change.

Accordingly, the stock market ended the week with a 5.7% decline – its worst weekly decline in more than two years, resulting from inflationary fears on top of trade-related rhetoric. Global stocks responded in kind, leaving other key markets down ~3% for the week. Selling pressure in equities was offset with money flows into bonds, and more precisely, Treasuries, which resulted in lower bond interest rates while narrowing the spread between short and long-term maturities. Meanwhile, gold jumped almost 4% for the week, as investors sought to play a little defense.

A trade war would be decidedly bad for all involved, but let’s not get carried away yet. I happen to think that this is a negotiating ploy which may or may not yield positive results. The best case scenario perhaps is that it leads to more productive NAFTA negotiations and détente with China. Already, there is word that trade representatives are meeting to discuss the issue.

There are certainly other avenues to settle some of these disputes, and it’s clear that by exempting our two most important trading partners, Canada and Mexico, from the most recent round of tariffs on steel and aluminum, that we’re working in third gear to send a simple yet poignant message to China.

It is true that much of the revenue of an average multi-national company comes from abroad. This makes the question of trade friction a bit pricklier. Protectionist tendencies by one nation on their own may not move the needle that much, but a more wholesale constriction in the freedom of trade – the flow of goods and services across borders – can have meaningful consequences for the profits of those companies in question.

So how much does China matter? In 2016, the US exported a total of $170 billion in goods and services to China, and imported $479 billion – leaving a deficit of $347 billion. Currently, the US is running a monthly trade deficit of around $30-35 billion, as of January. China is the US’s 3rd largest goods export market, and exports to China account for about 8% of total US exports, according to the US Trade Representative Office.

Top export categories include grains, seeds and fruit, as well as aircraft ($15B), electrical machinery ($12B), machinery ($11B), and vehicles ($11B). Within agricultural exports, soybeans are especially important, representing more than $1B in annual exports. While increasing rapidly, exports of services nevertheless account for just ~11% of exports, although the US maintains a net surplus in trade of services with China.

On the other hand, China is the largest US supplier of goods imports, accounting for roughly $462 billion in 2016. Primary Chinese exports to the US include electrical machinery ($129B), machinery ($97B), furniture/bedding ($29B), sports equipment and toys ($24B) and footwear. Interestingly, the US ranks a paltry 26th on the list of countries that import steel from China, according to research by Schwab.

I’m from the school of thought which favors free and open trade, but I will readily acknowledge that China is far from being a fair player. China has long required technology transfer from US firms wanting to do business in the country, and has consistently sought to undermine interests of foreign firms while building its own capability in notable areas where it is seeking global dominance by 2025.

So far, the World Trade Organization (WTO) has proven to be merely a paper tiger against China’s mercantilist aspirations since China joined the organization in 2001. If anything, predatory and sometimes arbitrary practices have accelerated in recent years.  Foreign firms find it difficult to complain about these discriminatory practices for fear of state retaliation, despite the frequent use of contracts which discriminate directly against foreign technology. This is the essence of the complaint the Trump Administration filed with the WTO this past week. The hope is this deliberate stand will serve as a rallying call to other similarly impacted countries, including many in the European Union.

Using the Trade Act of 1974 as cover, the Trump Administration took matters into its own hands. So far, the $60 billion in tariffs on steel and aluminum products have been met with only $3 billion in tariffs from the Chinese side, including new levies on pork and recycled aluminum. The big ticket items so far left off the list include key agricultural products like soybeans and airplanes, suggesting that it does plan to negotiate with the US on trade.

Nevertheless, speculation and anxiety will likely persist in the investment markets for the near term, as it will take a while to construct a solution to the trade issue. To that point, the US tariffs won’t go into force for 30 days and it is not clear whether a negotiated settlement will be in place by then.

Tariffs are a powerful drug for domestic interest groups and trade organizations. Take the 1930 Smoot Hawley tariff for example, which started off relatively benign to provide protection for US farmers, but took on a life of its own as more products were added to the mix – thereby tanking global trade and extending and depending the great depression. If sustained over a period of time, a modern tariff involving many partners would likely impact global trade as well.

Tariffs are by their nature inflationary. At a time when inflation is already beginning to perk up (due in large part to wage pressures), an unexpected inflation surge owing to trade disputes is not likely to be welcomed by the market, thereby fueling the volatility we’ve already seen thus far in 2018.

Focus on the Real Economy, OK

Aside from the trade issue, there seem to be two key schools of thought – the first reflects a fear of outsized inflation, which would lead to a reactionary shift in interest rates, and the second believes that relatively consistent global growth will allow inflation and interest rates to rise a bit more modestly.

To be sure, an all-out trade war would change the economic outlook to some degree, but let’s take stock of where we are right now.

• The economy is, by all measures, on sound footing. The current growth cycle, as defined by the National Bureau of Economic Research (NBER), is now 105 months long – dating back the summer of 2009. This counts for third longest on record, even though the running average 2.2% annual pace of growth in this cycle pales in comparison with the 3.6% posted during the 1990’s. Importantly, the recent tax cuts should increase the pace of GDP growth by +/-0.5% during each of the next few years.
• Despite some recent slowing in European growth, global economic growth is expanding as well, according to the Organization for Economic Cooperation (OECD). The OECD recently raised its forecasted growth for most of the G20 countries, and now expects global growth of 3.9% during both 2018 and 2019 – the fastest such pace since 2000.
• The US labor market is gaining strength, with 313,000 new jobs added during February in the non-farm sector. This was well ahead of consensus estimates and reflects the highest rate of job creation in almost 20 months. Meanwhile, civilian employment – a broader measure which encompasses small business, rose by nearly 800,000. The unemployment rate is 4.1%, and the labor participation rate recently increased a few ticks to 63%.
• Even with a weaker reading last month, average hourly wages are up 2.6% year-over-year through, down slightly from the 2.7% in January. The all-important wage trend is nevertheless healthy when judged against prolonged post-recession softness as well as long term inflation. Higher wages mean more disposable income, and in turn, consumption – which itself represents more than two-thirds of the economy. In fact, the growth in total annualized worker earnings over the six months is now trending more than 2% above the pace of the economy.
• The housing sector continues to push along, despite higher interest rates and some recent volatility in existing home sales. Both new and existing home sales were higher in 2017 than they were in 2016. In addition, new housing starts have increased eight years straight, and new housing permits – an indicator of future housing stock, is at its highest quarterly level since 2007.
• Core new orders for capital goods, which exclude the volatile defense and aerospace sectors, is up 6.3% over the last 12 months ended January; meanwhile, shipments are up 8.7%.
• Going further, the key opinion surveys for both US manufacturing and the service sector remain strong. The Institute for Supply Management (ISM) manufacturing survey, which represents about 12% of the economy, is in rarefied air right now, while the non-manufacturing survey is at a 12-year high. In addition, the responses related to future order flow were particularly enthusiastic.
• The small business optimism index published by the National Federation of Independent Business (NFIB) reached its highest level since 1983 last month (and second highest on record), with particular emphasis and optimism related to business expansion.
• The Federal Reserve increased, as expected, its target short term interest rate to 1.75%, citing an increasingly optimistic outlook. Keep in mind that, while this level provides more benefit to savers and helps to re-establish cash as a viable investment asset class, it nevertheless remains below the pace of economic growth. Also, as Brian Wesbury of First Trust notes, there is still more than $2 trillion in excess bank reserves in the system. We will need to monitor how this excess liquidity ultimately gets deployed into the economy, because it does represent feedstock for potential future inflation.
• Credit quality remains favorable across the board. Moody’s Analytics recently said they believe the global speculative-grade default rate for bonds will decline from 3.1% in February to 1.5% over the next year, due to improving economic conditions. Even the current rate is meaningfully below the average of 4.2% dating back to 1983. For the US, Moody’s expects the default rate to drop from 3.6% to 2.0% over the next year.

In sum, for the time being, I see the trade issue as being less catastrophic as some would make it out to be, barring a major policy mistake or miscalculation. History has proven that long standing tariff regimes do not, in fact, lead to growth, but rather drive trade down. Prices tend to increase for all partners involved, which hurts demand and disrupts the efficiency of global supply chains. If this spat simply leads to purposeful negotiation and results in at best, very modest concessions, I’d consider it a win for the Trump Administration.

Moreover, the backdrop for this is a fairly sound economy which should benefit from the 2017 tax legislation. Market fundamentals have simply gotten ahead of economic fundamentals, and the two are now playing catch up. With so many data points to track, sometimes it’s easy to get embroiled in the minutia of the moment and lose sight of the big picture – the economy is growing…

Volatility in reasonable measure is good for the market, and helps to firmly establish risk premium over other asset classes. While unexpected and/or rapid inflation is not as helpful, inflation in small measure is also good for the market, as it usually dovetails with economic growth. Interest rates are normalizing, and savers are benefiting from higher short term rates. As long as consumers spend, the Leading Economic Indicators continue higher and corporate profits expand, the near term case for growth remains.

Stay the course…

 Eric Boyce, CFA

Sources: US Trade Representative Office, WSJ, Federal Reserve Board, First Trust, Chas. Schwab & Co.