Wealth Management: Strategy blog – Trump, tariffs, Thucydides...
Strategy team - Kevin Gardiner (Wealth Management)
The sudden revival in trade and currency tension is the latest contributor to a growing wall of worry. How should we respond?
You can never rule anything out where Twitter-based policy is concerned, but this breakdown in the US-China tariff truce feels like it could last a while.
Political strategists will debate whether or not we face the classical “Thucydidean trap” - the idea that an established power (the US) will inevitably tussle with the new kid on the block (China). But Mr Trump is surely intent on securing his second term, and the 2020 election is still a long way off. China's patience may not stretch that far.
The prospective tariffs are still not large enough directly to turn US growth into recession. China's tariffs on the US don't amount to much, because the US sells much less to China than China sells to the US (that's the point). And while Mr Trump seems to forget that his own tariffs will be borne by US consumers as well as by China, they are still small relative to US and Chinese GDP, and their impact on China can anyway be muted by the Chinese government's tighter grasp of the economic reins.
The indirect impact on business confidence and investment plans might prove more potent. Competitive currency depreciations - what we used to call “beggar-thy-neighbour” tactics - could also have such an impact, though we doubt those will actually materialize.
It is not just US-China trade relations that are strained. Japan and South Korea are at odds in a dispute whose causes partly date back to the 1930s. Here in Europe, we face some disruption in trade between the UK and the European Union if the “no deal” Brexit materializes.
Outside the trade arena, geopolitical stresses and strains have also intensified, with potential flashpoints in Hong Kong and Kashmir joining those in the Middle East, North Korea and the South China Sea.
The threat to business and investor confidence is compounded by the lack of momentum behind the global economy to begin with. Germany in particular has not found its feet since the spring but instead continues to slow: industrial output is down 5% year-on-year, and a decline in GDP is quite possible in the second and/or third quarter.
The most visible manifestation of the growing wall of worry is the increasingly-sinister fall in bond yields, with almost one-third of the world's high-quality bonds now trading at negative nominal yields. Several European governments are nominally being paid to borrow for as long as 10 years and beyond, and quite a few corporate bonds have risen into negative yield territory (though we have yet to see a long-dated negative corporate coupon issued).
Such safe haven assets are very sensitive to inflation, and for investors to be bidding-up their value (higher prices push yields down) as they are doing - even as the supply of new bonds from some of the world's biggest borrowers, including the US government, also surges - testifies to the scale of concern.
Bond-buyers at these levels are either betting on a big economic accident, and/or think that inflation will fall sharply, perhaps also into negative territory.
The big central banks are promising - and in the case of the US Federal Reserve, delivering - lower short-term interest rates. But the flattening of yield curves - the gap between longer-term bond yields and short-term policy rates - is telling us that they are as much following the markets as leading them.
We are reluctant to follow the markets ourselves: we thought bond yields were prohibitively low even before this latest episode.
Our reading of the economic data is that while growth is slowing, it is not collapsing - though of course the evidence pre-dates the latest presidential tweets.
Manufacturing sectors are most exposed to trade risks; and within manufacturing, the influential auto sector is facing a perfect storm, as emission controls, electric vehicles, self-driving capabilities and (in Europe) Brexit are combining to cause massive re-tooling and disruption.
By contrast, service sectors are holding up relatively well. There are some exceptions: European banks' business models are under pressure; insurance premia continue to languish. (Global retailing too is struggling, as it migrates online, but this is hardly news, and business is not being interrupted, just relocated.) But overall, service sector business surveys, and with them labour markets, look resilient - even in Germany.
To some extent they always do: services are inherently less cyclical than manufacturing (not least because you can't stockpile them). But if there was a serious downturn looming before the latest trade news we would have seen it in the US labour market reports. And worrying though those indirect effects might be, we do not think that the latest trade spat is in itself a game changer.
What about the other possible explanation for the mood in bond markets? We do have some sympathy for the idea that the link between economic growth on the one hand, and inflation and bond yields on the other, can change: see our July Market Perspective. However, we don't see why that idea should suddenly have taken root just now.
For the time being, then, we respond by sitting tight, and continuing to advise that growth-related assets are the best way of securing long-term, inflation-beating returns.
It's not as if stock markets have to scale this wall of worry immediately. Stocks have had a remarkably-good run in 2019 to date - even net of the last week's setback - and we'd thought a tactical retreat for a while was already a possibility. If corporate profits hold up, that retreat could give the indices a decent run-up later on.
Because there is a good chance that profitability will stay healthy. Outside the most obvious stress points - exporters, autos, European banks, UK domestics, the new tech/communication giants - cyclical risks may be more muted, not least because the M&A and lending excesses that led to the last two profit collapses seem to be missing in this cycle. If we've been wrong on corporate earnings so far in 2019, they've been a bit stronger than we might have expected.
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