Hydra

Since the beginning of the year we took the view that, despite blustering rhetoric, the US-China trade dispute would be resolved within weeks of its initial deadline. Our optimism was grossly misplaced.

Developments over the past month have demonstrated that the bilateral trade dispute has escalated and morphed into a three-pronged global dispute: a trade war, an investment war and a technology war. America is also flirting with a currency war. As each dispute takes on a dynamic of its own, the likelihood that a resolution of one will facilitate the resolution of the others diminishes. 

It is difficult to assign full responsibility for the failure of the US and China to reach a trade deal. Chinese negotiators have often agreed on matters only to reverse positions in the hope of gaining better terms at the last minute. However, the form of the Trump administration’s positions may have been more damaging than their substance. History is never far from the minds of Chinese policy-makers. By raising issues of “dignity” and “sovereignty”, China is recalling the unequal treaties of the 19th Century. There is no prospect that China will acquiesce to a deal that can be packaged as a “victory” by the Trump administration.

The tariff dispute with China, however, is no longer the only serious source of risk for the global economy. The announcement of tariffs on Mexican imports, Trump has demonstrated that trade will remain a favoured tool of foreign policy, even if his own key economic advisors are counselling caution and despite the fact that his ability to do so under US law is questionable. This comes at a particularly unexpected time:  the USMCA (“new NAFTA”) has only been recently agreed, and the steel and aluminium tariffs were lifted in mid-May.

The technology war may be less disruptive to the global economy in the short term, but its long-term consequences are seismic. The designation of Huawei as a security threat triggers a chain of events that cannot be reversed, even if (as in the case of ZTE last year) certain exemptions are subsequently made. Chinese companies will now be focussed on self-reliance. Other countries will need to take sides. Many of the efficiencies gained by globally integrated supply chains are likely to dissipate.

An “investment war” may also be brewing. The Trump administration has deemed that research and development in the automobile and automobile parts sector is relevant to the national security of the United States. Rather than focus on imports, the White House states that “American-owned automotive R&D and manufacturing” are vital to national security.  It is not clear what “American-owned” companies in today’s globally integrated investment world means. The shareholders of Daimler and Ford, for example, are not fundamentally dissimilar: among the largest shareholders in both are the same institutions – ETFs from Blackrock and Vanguard, and some active fund managers. Does this mean that the US will introduce foreign ownership restrictions on US-headquartered automakers?  What does this imply for R&D undertaken by “foreign” companies in the United States, such as BMW’s research centre in North Carolina? These questions cannot be answered easily. What is clear is that recent developments introduce risks that will complicate future investment decisions, by incentivising companies to stay closer to their home markets rather than their customers.

While this three-pronged global dispute is brewing, a fourth may be added to the melee. The US Commerce Department has recently announced a proposed rule change that expands its ability to introduce countervailing tariffs when the US Treasury deems that foreign governments “subsidise” their products by weakening their currencies. If adopted, this rule will not only heighten the disputes between the US and China, but likely introduce new disputes between the US, Germany, Korea, Japan and other countries. It also raises questions regarding US obligations under the WTO and IMF agreements.

In all of the above areas, economic rationality has taken a back seat to political expediency.  What started as a trade dispute between the US and China over a bilateral trade balance, is metastasising to cover national security, immigration, and relations with many other countries. Like Hydra of Lerna, the Greek mythical multi-headed venomous serpent guarding the door to the Underworld, when cutting off one head, Hydra will regrow two.

What does this imply for markets?

These elements of risk come at a moment when the US economy is showing vulnerability. US consumer sector credit metrics are deteriorating. Corporate earnings have decelerated sharply, while the labour market shows no signs of slack. Increasing tariffs can be absorbed in one of two ways: a squeeze on profit margins or a rise in consumer prices. If the adjustment falls primarily on earnings, equity markets are at risk. If the adjustment primarily takes of the form of rising consumer prices, the combination of lower growth and inflationary expectations can have serious implications for the bond market.

There are multiple possible scenarios for the fixed income market.  At a basic level, the factors that underpin risks for equities are similar to those impacting credit spreads.  Indeed, spreads have widened across all rating segments, though they remain low by historical standards. Further spread widening should be expected, but this risk is most pronounced for High Yield and BBB credits. The diminished supply of higher quality bonds implies that spread widening for bonds rated above BBB is likely to be modest.

The trajectory of monetary policy and its impact on long term interest rates is less clear cut. Decelerating growth, and inversion of the yield curve, is putting pressure on the Fed to move towards cutting rates sooner rather than later, but how long-term rates behave is dependent on a multitude of factors. If inflationary pressures do rise, so will pressure on long term Treasury yields. But if growth concerns spike, and uncertainties regarding corporate earnings persist, there is little reason why long-term rates will not decline even further.

There are other possible scenarios. The US economy, despite recent signals, may not tip into recession. Indeed, disruptions to import supply chains can (in the short term) boost domestic production in some industries, albeit at higher costs. Under such a scenario, the Fed will unlikely cut interest rates, and long-term rates may indeed start rising again gradually.

For investors navigating these uncertainties, it is important to maintain focus on the long-term fundamentals. The late stage of the economic cycle, as well as the increasing cost pressures from high trade costs, point to lower earnings. Disruptions to global supply chains also suggest that future production will be less efficient than it is today. All of these factors point to a less hospitable environment for equities. In fixed income, widening credit spreads pose some risk, but for the highest quality of borrowers, investor’s returns can still be positive, even if long term rates rise.