Market volatility returned big time in October. We still think this Bull Market has more runway and self-corrections are healthy, but the price action this week has our full attention. Stocks never go up in a straight line, nor do they go up forever. Higher interest rates have created some turmoil, but our sense is the Market is merely recalibrating as it factors in the higher cost of capital, which came faster than perhaps expected. We do believe rates are rising for the right reasons, and a Market and US Economy at all-time highs require higher rates as a cooling agent. It quite often creates some turbulence.
Higher rates have been a top risk all year. The other has been trade tensions. Deals have been made with Mexico and Canada. Productive discussions continue with Europe and Japan. The outlier remains China. There’s been a lot of tough talk on trade between the US and China. A trade war has developed. It runs the risk of expanding. These are the top 2 economies in the world. The US has an unrivaled Gross Domestic Product, reaching $19 Trillion last year. China is second at $13 Trillion. The rate of growth in the United States has actually accelerated this year. The growth rate in China continues to shrink but is still growing considerably faster than the US. The sustainability of growth rates for both nations are in question and present the challenges that the global economy faces. The US and China are the most significant players in trade. The US is the largest importer of Chinese goods. With a population of 1.4 Billion, China is the largest consumer market. It’s a really big deal. This has had a great influence on the Market turmoil.
China’s economic boom over the last couple of decades largely relied on the U.S. consumer. Its economic rise created a huge trade deficit. That is a very normal relationship between a mature and an emerging market economy. Much of the surplus was ploughed back into U.S. Treasuries, which built up its foreign reserves for Beijing but also helped keep U.S. bond yields low, the U.S. economy humming and the American Consumer spending. The voracious growth has resulted in China becoming the 2nd largest economy in the world, behind only the United States. China became the largest buyer of US Treasury securities. China is not an emerging market nation; China has already emerged. China’s economy continues to transition from exports to consumption. Exports were 35% of the Chinese economy 10 years ago. It’s half that today. A big chunk of Chinese exports have imported components within. Chinese manufacturing has increased significantly over the years. The United States remains China’s largest export market.
10% tariffs have been implemented on $200 Billion of Chinese imports to American soil. They will go to 25% in January if a trade deal is not achieved. The 25% number is not random. For perspective, the United States does, in fact, pay a 25% tariff on cars sent to China. Conversely, China only pays 2.5% on cars that come to the United States. Now, there aren’t nearly as many Chinese made cars that come to the United States, and none of them are a Chinese brand. Most are Volvos.
The fact that the recent tariffs started at 10% was telling in our minds. We think a deal ultimately gets done. If the White House didn’t want a deal, it would have likely gone straight to 25% tariffs, which would really hurt the American consumer, which would directly hurt the US economy. A 25% tariff on all Chinese imports would shave roughly $8 in earnings from the S&P 500, which is expected to earn $179 next year. That would definitely be felt and likely drive stocks lower. The 10% tariff is very manageable, in the grand scheme. It accounts for $20 Billion of a $24 Trillion economy, which has experienced very little inflation. We Americans are used to seeing inflationary pressures at the grocery store and the gas pump. The sellers of these impacted consumer goods, such as Wal-Mart, Target and Amazon, could choose to eat those new duties and see their profit margins decline a bit. They could also send some or all of the cost increase to consumers. Some of the burden will be shouldered by the Chinese exporters. Short-term, it will work itself out.
Come November, the Chinese government will have more expansive powers to inspect foreign companies intellectual property under its new cybersecurity policies. Foreign businesses have pushed back on this new set of rules calling it an abuse of power which could set up leaks of trade secrets and other proprietary information to domestic Chinese companies. There hasn’t been free and fair trade with China for decades, and this is just another example. To do business in China, American and other international companies will have to provide full open access to the Chinese government in the spirit of cybersecurity.
This comes after a Bloomberg story circulated last week that China had inserted spying chips in various hardware devices, including Apple and Amazon devices. Both companies, as well as the U.S. Department of Homeland Security, have denied this claim, but it certainly was an attention getter and seems like something that could happen in the age of cyber warfare. Whether fact or not, it certainly is going to be in the back of the minds of corporate and government leaders when doing business there. Every foreign company desperately wants access to this vast Chinese consumer market. But at what cost?
This is all really complicated stuff that’s going on. The New World Order is quite different than the Post-World War II Order of the last 7 decades. There’s a compatibility issue between the Western model and the Asian model. The West has been about free market capitalism. It certainly requires oversight and runs into trouble occasionally. China is a communist country. China is not a free market economy; it’s very much a managed economy. For China, exports over the years were used to increase employment and income while gaining global market share. This trend has grown rapidly under President Xi who has effectively secured power for his lifetime. China has used unfair trading practices for 2 decades, with no penalty from the World Trade Organization. Middle-class incomes have been static in the US as we’ve imported a vast amount of deflation from China over the years. The US isn’t the only nation that has expressed dissatisfaction and lack of trust. China is experiencing tensions with many nations beyond the United States. Japan, Australia, and India are atop that list. The new NAFTA deal specifically speaks to dealings with a “non-market country.” The intent seems to try to force nations to choose between China or the US. The US continues the dialogue with Europe and Japan on trade. If this is a template for future trade deals, then things could get tougher for China.
The thing is, short-term, there isn’t a lot that China can do. But they are no doubt studying retaliatory options. The US Treasury market is nearly $16 Trillion in size. China owns $1.2 Trillion of them. They’re the largest foreign owner. It’s been rumored that China has become sellers of Treasuries. However, actively selling Treasuries would actually hurt them more than help. Perhaps they’re just letting them roll off without reinvesting the proceeds. This has likely contributed to higher interest rates in the US. There is another thing they can do strategically. The Chinese Yuan currency has fallen nearly 10% against the Dollar in the last six months, raising speculation that China has been deliberately weakening its currency as trade tensions have escalated. The Treasury Department has thus far not called China a currency manipulator. China knows it needs to be careful here if it wants to be viewed as a global leader. So for now, China’s options are somewhat limited.
Calling China’s bluff at a time when the US is in a position of strength is a strategic move. There are some parallels to President Reagan’s approach with the Soviet Union, ultimately putting an end to the Cold War. Reagan called the Soviet bluff by outspending them. He believed the Soviet economy was weak at the core and its power was unsustainable. This has been a cold trade war of sorts with China. At this point, economically, China seemingly needs us more than we need them. But that won’t last forever. China has shown some vulnerabilities. It is taking some drastic moves to protect its economy from the trade tariffs. China has seen its economy triple in size in a decade. The problem is, China’s debt has quadrupled. Some accounts have China’s debt now over 250% of its gross domestic product. China wants to project strength to the rest of the world. But some monetary policy moves of late have actually done the opposite, which has put pressure on the Chinese Stock Market. It’s down nearly 25% this year.
Talks would be soothing. But a sustainable fair deal is required. President Xi and President Trump are expected to meet while they attend the G20 summit in November. If they fail to reach an understanding and develop a path to a more workable relationship, the Market will most likely begin pricing in the 25% tariffs slated to start in January. That’s part of what’s been going on this week. But this fight isn’t just about tariffs. China is focused on being the dominant player in the Digital Age, with a sharp focus on Automation and Artificial Intelligence. This is not just a 2018 or 2019 issue. This has profound consequences economically, politically and militarily for decades to come.
We definitely expect choppy price action to continue.
Have a nice weekend. We’ll be back, dark and early on Monday.