While most of the cards dealt are the same, fear has joined the players’ table. A quarter ago, we started to see signs of anxiety across global equity markets over President Trump’s trade war threats and a more hawkish Fed. Yet, fundamentals were still strong and earnings growth, with some small exceptions, remained solid. One quarter later, we have entered risk-off territory.
We are seeing all the obvious signs of risk aversion: developed markets are back to outperforming emerging markets and in developed markets, the US reigns supreme. Needless to say, in equity markets quality is outperforming value.
So, what has changed? Well, not really much from a fundamental viewpoint: the global growth cycle is still improving, earnings are still growing nicely (expectations for both developed and emerging markets are around 15% for the year), and even trade numbers are still robust. Yet, while most of the cards dealt are the same, fear has joined the players’ table.
Don’t get me wrong, markets have good reasons to be fearful. A perfect storm of potential threats has appeared on the horizon: a more hawkish Fed, protracted trade hostilities and geopolitical concerns (particularly in emerging markets and Europe). None of these threats per se could halt the global growth cycle but, put together and pushed to their limits, they could be powerful gamechangers. A strong dollar, collapsing currencies in countries with widening current account deficits and a weak credit profile, as well as Purchasing Managers’ Indices starting to roll over are a symptom rather than a cause of those same fears.
Let’s not forget that a Fed tightening cycle has not per se been negative for equity markets, as long as it responds to improvements in the global economy (think 2004-06). However, a steeper tightening path to stem inflationary pressures that are not accompanied by an improved growth outlook, is likely to have a negative impact. So the key issue becomes that, if the current trade disputes erupt into a full-fledged trade war, we are left with inflation-led tightening in the US at the same time as the global growth cycle taking a turn for the worst.
The main question to ask is what will happen with the trade disputes, particularly between China and the US. We just saw the first tariff increases on USD 34 billion of imported goods being implemented on both sides. This has little impact on either country from a fundamental viewpoint, representing less than 0.3% of China’s current GDP and easily offset by stimulus. Another USD 16 billion is in the cards and will likely be implemented soon. Still, these are small numbers. What happens next is key. In our opinion, as the stakes at risk are high for both countries, negotiations are likely, but the process will not be straightforward. Both President Xi and President Trump are likely to maintain a tough stance: Xi to push through tough reforms and Trump to help his party win the mid-term elections.
What happens if we are wrong? What happens if negotiations don’t succeed and Trump pushes through tariff increases on another USD 200 billion of Chinese imports? And then maybe China retaliates with measures against US companies investing in the country? As we discussed in our last Fundamental Equities Quarterly, we have to be mindful of the risks, and should all negotiations fail, and a full-fledged trading war break out, equity markets would face the proverbial double whammy. On the one end, earnings might be hit as both exporters and importers, depending on what side of the trade tariffs they sit, suffer. On the other end, we could expect inflationary pressures to ramp up in the US, prompting the Fed to hike rates not in line with the improvement in economic growth (as it has done thus far) but to stem inflation.
The outcome will be, as it often is, binary. The trade war either happens or it doesn’t. With current sentiment, positive news on the trade disputes could ignite a rally. How long that will take, and the volatility that we will have to endure in the meanwhile, will have to be weighed against our risk budgets. For developed markets, we have become less upbeat. Unless we get positive news on the trade disputes, volatility is likely to stay high, as the market is discounting increasing risks of escalation at the same time as we expect declining Central Bank support.
In emerging markets, sentiment has weakened. There have been outflows since May and emerging bond spreads have been widening. Most global investors will now take a wait-and-see approach to see what happens on the trade side and on emerging currency volatility.
Make no mistake, even if China and the US come to an agreement on their trade disputes, the two countries are likely to be at odds for the years to come. The political and economic relationship between China and the US has changed dramatically, and any expectation of the two becoming BFFs over the next ten years would be unrealistic.
When on 24 May 2000, the US House of Representatives voted to award China permanent normal trade relations (effectively backing Beijing’s bid to join the World Trade Organization), frankly, they didn’t know what was coming. At the time, the US political elites held the view that as long as China integrated more into the world trade system, its economy would become more market-oriented, implying that state control would reduce, and ideologically China would draw closer to the western world. Instead, the consolidation of power by President Xi has shown that while the might of China’s size and power in the world has increased, its ideology has not drawn closer to that of the US and is not showing signs of doing so. The Belt and Road and Made in China 2025 strategies are perceived by the US as China challenging the established world economic and political order. Therefore, the issues between the two countries will not end with negotiations on the current trade frictions but are likely to resurface from time to time under different disguises, when not on trade, on investments, maybe on technology, why not on politics and let’s not forget currency.
Yet, what we need now is a resolution of the trade tensions for global markets to get off their risk-off stance. For the US-China relations, one can never tell what the future holds, but my guess is that eventually markets will get used to the two most powerful countries in the world being at odds from time to time, and, depending on the battle, will be choosing the winner.