The Trade War Has Officially Begun

The Trade War Has Officially Begun
  • U.S. equities remain resilient as the global trade war escalates. The impact on GDP may be limited, for now, but uncertainty is rising which has increased volatility and been a headwind for international stocks.
  • Once again, U.S. corporate earnings have been particularly strong, as companies acknowledge the growing concerns but cite little negative impacts from tariffs.
  • We are slightly reducing our international exposure, however are cautiously optimistic that they will bounce back once the trade fears subside.

While U.S. equities have performed well in 2018, the same cannot be said across most asset classes.  International stocks have continued to suffer and are mostly in negative territory year-to-date.  While developed Europe is roughly flat, developed Asia/Pacific is down 2.49% through July 31, and emerging markets are negative 4.61%.  This is quite a large dispersion from U.S. stocks, which in aggregate are up roughly 6.6% over the same time span.  Small cap U.S. stocks continue to lead the way and are now up about 9.5%.  Bonds meanwhile, are still struggling in the face of higher interest rates and rising inflation expectations.  The broad investment grade bond index is down 1.63%, however short-term treasuries and high-yield bonds are both slightly into positive territory.  Even commodities, which at one point were experiencing high-single digit returns this year, are now in the red as trade war fears have precipitated weaker demand expectations.

Looking towards the second half of 2018, one cannot ignore the growing fear that a global trade war could have the potential to dismantle the positive growth cycle which has presided over the past several years.  We have discussed the implications of a trade war multiple times over the past few months as the rhetoric has intensified, and as of now it appears that this dispute is likely to get worse before it gets better.  While we continue to believe that the impact to the overall economy should be limited in the short run, the market is more forward-looking and has responded with higher volatility and a more cautious outlook on future growth.

As the trade war fears escalate, the risks continue to mount and tilt towards the downside.  One concern is how the markets here in the U.S. have been mostly complacent about the trade risks, based on the notion that the tariffs only apply to small percentage of GDP.  This is true, however the risks to international markets may be more significant, especially for those countries whose exports make up a significant portion of their economy.  In the table below, we list the trade balance for countries in the G20, and also highlight the balance as a percent of GDP.  The U.S. has by far the largest trade deficit, while Germany and China have the largest surpluses.  However, China’s surplus only accounts for 3.7% of their GDP, while Germany’s makes up 8.9%, a sizeable difference.  Going forward, as the trade war escalates, those countries with higher surpluses in relation to GDP may be more susceptible to weaker growth.

Another byproduct of the trade war is greater uncertainty for businesses, especially multinationals which are unsure of how this will play out.  A perfect example is Harley Davidson, the American icon motorcycle manufacturer, which is moving some production overseas to avoid retaliatory tariffs and to meet international demand.  However, while most companies have acknowledged the growing risks that a trade war entails, the majority of companies in the S&P 500 are not witnessing a negative impact from tariffs.  We are currently about half way through 2nd quarter earnings season, and roughly 44% of the companies that have reported have cited tariffs in their post-earnings communications, according to FactSet research.  Of those companies, 61% have acknowledged little-to-no impact to growth in the 2nd quarter or future quarters.  It should also be noted that the U.S. is once again in the midst of an extremely good earnings season.  So far, 83% of companies in the S&P 500 have reported positive earnings surprises, which is the highest percent over the past decade.

There is no such thing as a good time to initiate a pointless and destructive trade war.  However, if there was, there couldn’t be a better time than now given the strength of the U.S. economy and the fundamentals supporting further growth.  Even with all the tit-for-tat exchanges and tariff threats between the U.S. and our major trade partners, friends and foes alike, the expectations are that the impacts will have a muted effect on GDP, at least here in the U.S.  However, according to the World Economic Outlook by the International Monetary Fund (IMF), the U.S.’s imposition of tariffs could reduce global growth by 0.5% by 2020.   The IMF also reported that global growth could reach 3.9% in 2018 and 2019, but that “the expansion is becoming less even, and risks to the outlook are mounting.”  For now, the U.S. recently announced 4.1% annualized GDP growth in the 2nd quarter, which was a tad below expectations but very strong nonetheless.  Looking forward, as of August 1, the Federal Reserve of Atlanta’s “GDPNow model” is estimating 5.0% growth in the 3rd quarter.

Are the tariffs just a distraction from an otherwise optimal international opportunity? This might be the case, considering the growth potential overseas along with more attractive valuations compared to the U.S.  However, the recent uptick in volatility cannot be ignored, and there may be substantially more systematic risk for international stocks than there was just a few months ago.  Europe is faced with several headwinds including political disarray in Italy, dragged out Brexit negotiations, and a decline in manufacturing growth.  Recent data showed Eurozone GDP growth of just 0.3% quarter-over-quarter, the weakest growth in two years, meanwhile inflation is creeping higher towards 2%.  While we don’t think these are recessionarysignals, we do believe that it may be prudent to pare back some developed international exposure in lieu of domestic exposure.  Emerging markets may continue to struggle in the short run, especially if the U.S. dollar remains strong as it has this year, but we believe in the long-term growth story and still favor a modest allocation in our models.   As we mentioned earlier, the trade war rhetoric could possibly get worse before it gets better, however we do believe in the overall resiliency of the global market.  Given our risk-focused approach to investing, we will continue to closely monitor these global events, and take further action to reduce market risk if necessary.  Our focus will remain on U.S. equities as it has been, given the positive fundamentals driven by fiscal stimulus and strong corporate earnings.  We see more risks (and more volatility) ahead, therefore we will proceed with caution as we enter the 2nd half of 2018.


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